By Terry Flanagan

ETFs Test Market-Making Skills

07.18.2013 By Terry Flanagan

With exchange-traded funds playing an increasingly important role in portfolio management, the ability to accurately price the instruments has placed a premium on market-making skills.

“ETFs are a unique breed of financial instruments,” said Chris Hempstead, director of ETF execution services at WallachBeth. “Order execution requires the ability to navigate these markets and compel liquidity providers to offer customers the most aggressive bids and offers.”

With upwards of 1,500 listed products in the U.S. alone, the secondary market for ETFs remains evolutionary, and liquidity in many ETFs is often elusive, despite the sophistication of screen-based electronic markets.

“ETF wrappers provide an efficient way to gain access to an index,” Hempstead said. “But not all ETFs have sufficient depth of quotes, so you need to partner with someone who knows how to value an ETF. Even SPY, the most liquid ETF, doesn’t trade exactly at NAV [net asset value]. For less liquid ETFs, the spreads could be considerably higher.”

Sourcing liquidity at the right price for ETFs, ETNs and CEFs requires an advocate with a wide net, unhindered visibility and unencumbered market access, one whose pool of liquidity extends beyond traditional screen-based markets and the boundaries that conventional brokers are constricted to. “Because we’re product experts we are able to use both traditional and tech-savvy means to quickly and efficiently canvass a broad and diverse universe of reliable liquidity providers,” Hempstead said.

Continued advisor demand for ETF managed portfolios pushed assets in this universe ahead in the first few months of 2013. Through March, strategies in Morningstar’s database collectively held $73 billion, representing a 12% growth in the first quarter and 22% increase over the total in September 2012.

“Professional money managers are packaging portfolios of ETFs into investment strategies to meet a wide array of investor demands, and are providing access to both stand-alone investment strategies and one-stop, complete-solution offerings,” said Andrew Gogerty, ETF managed portfolio strategist at Morningstar, in a report.

ETF managed portfolios are investment strategies that typically have more than 50% of portfolio assets invested in exchange-traded funds. Primarily available as separate accounts, these portfolios represent one of the fastest-growing segments of the managed-account universe.

Growth in assets from increased advisor demand is being driven by multiple factors. “The fiduciary standard continues to move forward as the baseline philosophy for managing client portfolios, and, as a result, growth in the fee-based model is tilting portfolios toward lower-cost, broad-based investments for a larger part of client portfolios, with a focus on asset allocation,” Gogerty said.

In addition, ETF strategists allow advisors access to institutional-type diversification and portfolio management.

“ETFs make sense in actively-managed portfolio, especially is the ETF offers good pricing,” Hempstead said.

Prior to joining WallachBeth in January 2012, Hempstead served in senior market-making/risk-management roles for several of the industry’s leading ETF market-makers, including a 9-year tenure as senior ETF Specialist for global proprietary trading firm Susquehanna International Group, and thereafter, as a managing director, ETF Trading & Development for Van Der Moolen Capital Markets; a role that included the development of that specialist firm’s ETF market-making platform, oversight of 9 traders, and design/implementation of ETF execution strategies.

In 2009, Hempstead was recruited by Cowen & Company to serve as head of ETF trading, during which time he was instrumental in designing that firm’s proprietary ETF quoting and algorithmic strategies, overseeing development of order management systems, and maintaining critical relationships with institutional clients and ETF issuers.

Hempstead plays an integral ‘air traffic controller’ role for WallachBeth’s ETF cash desk. “We are an outsourced trading desk for institutions require sophisticated price discovery techniques,” he said. “Securing best price at a given moment for an ETF requires a completely different price discovery process when compared to the industry-typical approach for ‘best execution.’”

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