It’s been a banner year for ETFs. In Europe, ETFs saw over €120 billion of inflows to the market through September 2021 — already a record for any calendar year.
Alongside the flows, ETF trading volumes and product launches are also going up. There’s a growing amount of usage and trading in ETFs as things like thematic ETFs, ESG funds, and crypto ETPs come into the market.
With the space accelerating, there is a greater sense of choice (and more competition) in the market than ever. To help Bloomberg users understand ETF trends and enhance their ETF execution strategies, Bloomberg recently hosted a webinar to share knowledge and insights from several leading experts. Read on to learn how our participants are navigating a shifting ETF landscape.
Getting started with switches
One aspect of the ESG trend is that fund managers are rebranding and relaunching existing ETFs to switch to an ESG strategy. This requires shifting out the underlying asset holdings — which requires a risk- and cost-conscious approach to trading.
“In any switch trade, we’re trying to minimize execution costs and also minimize trading risk,” says Simon Barriball, Head of ETF & Portfolio Trading at Virtu ITG Europe Limited. “Perhaps you’re moving from an S&P 500 ETF to an MSCI US ESG product. There’s going to be a reasonable level of correlation between those two products. So where there’s overlap or correlation, it makes sense to look at doing the trade as a contingent pair, where you’re asking your counterparts to price the trade as a round trip cost — factoring in the fact that they’re going to get both sides of the trade.”
Doing so minimizes timing risk, as both parts of the trade are executed at the same time. This kind of cross-hedging “also means that anybody who’s making a NAV or risk price can make a tighter price for you,” says Barriball.
Navigating NAV versus risk
Since the mechanics of a NAV trade require understanding a future price and backdating a trade — which can potentially mess up a fund’s valuation process — firms need to make careful decisions as to whether they opt for a NAV or risk price.
“Generally it’s going to come down to whether you want to trade that risk or NAV, and they’re not the same thing by any stretch,” says Barriball. “They’re not actually the same type of risk transference. In a NAV trade what you’re effectively asking someone to do is pre-hedge the trade that you’re giving them. And that becomes more of a challenge if the underlying [products] are particularly illiquid.” (If they are illiquid, then the other party’s “actions in pre-hedging — in doing that creation or redemption for you — are going to have bearing on what price you get at the end of it,” adds Barribal.)
“[You have to] think about what the overlap is, about what fits for the fund that’s looking to do the trade, and about what the mechanics and the underlying basket look like and how that will bear out differently between risk and NAV,” says Barribal.
In his experience on the buy side, Jason Conan-Davies — Head of Trading at Nutmeg Saving and Investment Limited — reports that his firm has “tended to go in the direction of risk.”
“There’s been a lot of volatility in the last year and half compared to the three years previous, so whatever sort of price we see on the screen when we submit the trade for NAV will be different from when the NAV is actually struck,” says Conan-Davies. “We want to lock our pricing. We don’t really have the operational facility to wait a day — or sometimes two days actually, depending on if the underlying is in Asia — for the actual NAV price to be printed on the trade.”
Reaching the right execution
Switching aside, the appropriate execution approach varies depending on the strategy and market conditions.
“Take size, for example,” says Bernardus Roelofs, Head of ETF Institutional Sales & Trading at DRW, of one approach. “A growing number of asset managers are sending their smaller trades — let’s say smaller than €500K or €1million — to an automated rules-based solution via the RFQ platforms. One rule can be that they need three prices and they just take the best price without looking at it.”
Since this approach is automated, it’s “much more efficient” and normally takes one second. Alternatively, according to Roelofs, asset managers can take a manual approach — waiting for more market makers to price, which can take up to ten (and sometimes longer than 30) seconds.
“The benefits of that is that more market makers are pricing these ETFs, but it also allows a market maker the time for price improvement,” says Roelofs. “An important aspect of that is that you really can find the market makers who are good with those products. Another [piece] is the timing aspect: when the underlying markets open. I think this is key. [Depending on timing,] the spreads can be a little bit wider, but it might offset the risk of waiting hours to trade against a much higher or lower price.”
Embracing targeted automation
Knowing which market markers are stronger with which product types is part of the knowledge firms can impart in their automated technologies. The sophistication of automation tools lends themselves to being used more and more across the ETF ecosystem.
Firms today are able to “program an algorithm to almost act like a trader,” says Conan-Davies, and lessens the operational risk of any trade being left outstanding for too long.
“Any tool that we can have to improve the speed and the efficiency of the way we execute is going to be welcomed,” says Conan-Davies.
That’s especially true for small transactions.
“Clients want to spend their time on the trades that add alpha to their portfolio,” says Barriball. “And those small trades don’t add alpha. So why waste your time spending a lot of time doing stuff manually? [Small trades are] where we’re seeing automation. People still want to be much more hands-on with the big trades that are really going to be significant in terms of alpha in the portfolio.”
Recognizing CSDR uncertainty
The Settlement Discipline Regime (SDR) — the third phase of the Central Securities Depository Regulation (or CSDR) — has been delayed to February 2022. CSDR aims to drive higher rates of efficiency and liquidity in the European securities markets, but right now it’s creating questions in the ETF space.
“The key uncertainties are what’s the buy-in regime, what’s the fine regime, and also to what extent do RFQ trades need to end up in CCP?” says Barriball. “That’s not going to be free. And who’s going to pay that?”
The expectation is that the regime will lead to increased cost to trade. The costs “which will almost certainly be wider spreads charged by market makers for the added risk of assuming the trade,” according to Conan-Davies, are of great concern to the buy side. “SDR will also likely make it more costly for market makers to deliver ETFs in a timely manner – Market makers may have to create ETFs in the primary market rather than wait for inventory in the secondary market to meet the delivery demands that the SDR regime will invoke. This could be expensive, especially when we are discussing certain ETFs with associated stamp costs when creating on the primary market.”
“We’re going to have to shift focus to making sure we get [each] delivery and make sure the matching is correct as well, because there’s penalties associated with that,” says Conan-Davies. “All of these things are new considerations that will impact our operational capabilities that we have at the moment and the operational capacity that we’ll need to actually trade ETFs.”
Crypto gaining in institutional interest
Firms will need the operational capabilities and capacity to support crypto products, as well, to meet the needs of both institutional and retail customers.
“Currently, the crypto ETP market mix is mainly split between institutional and retail at around 20% and 80% [respectively], so it’s very retail focused,” says Roelofs. “When you compare that with the normal ETFs in Europe, there you see institutional is 80% and retail still 20%. However, we are seeing a trend for crypto ETPs in that institutional investors want to know more about the crypto investment case, as well as more on how to trade crypto ETPs. This interest was confirmed in my own experience by several larger institutional investors, who wanted to work with us [at DRW] because of our crypto ETP market making capabilities. So there seems to be an institutional adoption of crypto ETPs.”
Greater institutional adoption of ETPs will likely grow interest in exchange-traded products, at large.
“This will all drive the industry,” says Roelofs, “and I think that’s great.”
For more information, click here to watch Bloomberg’s on-demand webinar for a comprehensive overview of how to enhance your ETF execution strategy.