Excerpted from a survey commmissioned by Jane Street
• 20% of traders surveyed executed ETF blocks trades in excess of $100m over the past year. Almost one third of respondents stated they execute more than 50 ETF trades a month, with European institutions the most active of all, with 42% reporting they trade at this frequency.
• Risk-priced orders are the most commonly used means of trading ETFs off-exchange, with 41% of respondents citing the methodology as their top preference. Beyond risk pricing, 24% of institutions most commonly used algorithmic trading and 23% used net asset value (NAV) pricing.
• ETFs that offer exposure to less liquid underlyings and exhibit price volatility are often prime candidates to be traded using risk pricing, in order to provide investors with a certainty they would not gain through NAV pricing.
• As investors seek to bolster allocations to more complex ETFs tracking more illiquid underlyings, the capabilities of market makers are coming into greater focus. Key advantages include their willingness to commit firm capital, their investment in trading technology and their concentrated focus on ETFs.
In an ETF trading survey commissioned by Jane Street1 , 210 institutional investors shared insights into how they approach ETF trading, the counterparties they work with, and how they evaluate liquidity.
Across the 210 responses, approximately 41% are from the US; 38% are from Europe; 21% are from Asia. Many of the participants are large institutions, with 22% managingmore than $100bn (€85bn) in assets. More than half of the institutions surveyed manage more than $10bn.
Frequency and size of trades
Across the universe of respondents, the average institutional investor reported 19% of assets allocated to ETFs. A hefty percentage of these firms are very active participants in ETF markets. Almost one third stated they execute more than 50 ETF trades a month, with European institutions the most active of all, with 42% reporting they trade at this frequency (see figure 1). Just over half of Asian firms say they trade ETFs 10 or fewer times a month.
Institutions are also trading ETFs at scale. Although the size of the largest trades by each institution is invariably linked to its total AUM, it is notable that more than 21% of traders surveyed executed blocks in excess of $100m over the past year (see figure 2).
The survey revealed that risk-priced orders are the most commonly used means of trading ETFs off-exchange, with 41% of respondents citing the methodology as their top preference. Beyond risk pricing, 24% of institutions most commonly used algorithmic trading and 23% used net asset value (NAV) pricing (see figure 3).
There are marked disparities by a firm’s domicile and size. US institutions favour risk pricing to a much greater extent than their Asian counterparts – by 44% to 16%. Likewise, heavyweight funds, with assets under management in the $50bn–100bn range, outstrip funds with assets under management of $1bn or less in their use of risk pricing, by 56% to 29%. It is likely the case that larger funds trade more jumbo tickets off-exchange, and are simply more sophisticated in general because of their scale.
A risk-priced trade passes the market risk of a trade from the investor to the counterparty instantaneously. The advantages of risk pricing are explained by Darshan Bhatt, co-founder and portfolio manager at US-based global macro fund Glovista, which allocates 60% of its assets to ETFs.
“If we are trading an ETF where the on-screen liquidity is extremely large versus the size we are trading, we would typically use an electronic algorithm to execute that. In cases where our trading size is larger than what we see on-screen, or exceeds the average daily volume (ADV) – but we know the underlying securities are very liquid – that’s when we use risk pricing,” says Bhatt.
For products that trade thinly or reference less liquid underlyings, or both, risk pricing can yield benefits to institutions conducting block trades. Price certainty at the time of the trade can be especially valuable in uncertain market conditions: “Where there is a spike in volatility, unless we have a strong opinion as to which way the market is going to move, we will try and execute as quickly as possible, which will be a risk trade,” says Will Wall, trading and operations manager at US-based Riverfront Investment Group.
A variety of firms compete for ETF orders, with traditional investment banks jostling for position alongside agency brokers and independent market makers (see figure 4).
Agency brokers pair liquidity seekers with liquidity providers. They are the most commonly used counterparty – 34% of institutional ETF traders report working with agency brokers.
Investment banks typically provide all-in-one solutions, including but not limited to trade execution research, custodial services and securities lending. Globally, 27% of institutions are using investment banks for their ETF trades.
Independent market makers typically trade for their own account, and often focus on ETFs specifically. Some 29% of all institutions surveyed are working with market makers to execute ETF trades. In Europe, 36% of respondents are using market makers to execute ETF trades.
As investors seek to bolster allocations to more complex ETFs tracking more illiquid underlyings, the capabilities of market makers are coming into greater focus. Key advantages include their willingness to commit firm capital, their investment in trading technology and their concentrated focus on ETFs.
Institutions have to weigh up a variety of factors when deciding how to trade a certain ETF. High on the list is the selected fund’s liquidity.
Survey respondents have a sophisticated understanding of the nature of ETF liquidity, with firms identifying ADV and the liquidity of the underlying securities as the two most favoured gauges (see figure 5). US and Asian investors tend to lean on ADV to a greater extent than their European counterparts, which may reflect the greater amount of on-screen ETF liquidity available in the US. For their part, European institutions favour bid-offer spread, a traditional measure of how eager market participants are to provide liquidity.
Considerations understandably vary depending on trade ticket size. Institutions can allocate to ETFs in creation unit sizes or larger, where primary liquidity is often the key metric. They may also need to trade around their position from time to time, and here the liquidity of the secondary market tends to be more important.
Survey respondents reported that liquidity is of greatest concern when trading high-yield fixed-income ETFs, closely followed by emerging-market equity funds and commodities-based products. Developed-market equity ETFs prompted the fewest concerns.
ETFs that offer exposure to less liquid underlyings and exhibit price volatility are often prime candidates to be traded using risk pricing, in order to provide investors with a certainty they would not gain through NAV pricing.
As institutions increase their use of ETFs, they have also grown more discerning regarding whom they trade with and how these trades are executed. Looking ahead, this is a trend that may accelerate as institutions expand their ETF allocations to encompass funds tracking less liquid and more volatile assets. Emerging-market equities and high-yield credit are good examples. Here, selecting an appropriate counterparty and trading strategy can help investors achieve best execution.
Additional factors may influence institutions’ behaviour when trading. A tighter focus on trade execution will make institutions more price-sensitive. This is especially true in Europe, where the rise of RFQ platforms, coupled with incoming regulation, will push firms to be more discriminating in their selection of counterparties. Indeed, certain market participants are already reassessing their counterparties ahead of the implementation of MiFID II.
Excerpted from a survey commmissioned by Jane Street
RFQ platforms in vogue
The burgeoning worldwide popularity of request-for-quote (RFQ) platforms should encourage firms to put a broader array of counterparties in competition, and could nudge
investors to be more discerning when it comes to counterparty selection. Services provided by Bloomberg RFQE and Tradeweb allow institutions to conduct real-time auctions with multiple broker-dealers in pursuit of best execution. 32% of respondents globally said they use these platforms to submit block trade orders, with Europe leading the way at 41%.
“I have been using Bloomberg’s RFQ platform for the past two years and it’s been great,” says Will Wall, trading and operations manager at US-based Riverfront Investment Group. “The old-fashioned way was you’d either pick up the phone and try and call as many people as you can in a short period of time, or just send out instant messages and try to aggregate all that information yourself. The RFQ platform has been very helpful in consolidating all of that information.”
Use of RFQ platforms among European institutions may continue to increase in anticipation of the second Markets in Financial Instruments Directive (MiFID II), which comes into force in January 2018. The directive classifies RFQ platforms as multilateral trading facilities, one of three types of permitted trading venues under the rules.
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