Emerging markets: An insight into the intricacies of market making ETFs

Henry Reece gives an overview of the processes involved in market making

In 2010 the underlying MSCI EM index returned over 16%* and the main tracking ETFs from iShares, Lyxor and db x-trackers boosted their shares in issue by between 40%-90%. Assets under management in these three European funds topped $15bn at the end of the year and while widespread unrest in the MENA countries in Q1 2011 has driven a spate of redemptions in the funds, assets currently stand at around $13bn*.

With the growing popularity of ETFs as a tool for gaining exposure to these markets, we thought it would be useful to give investors an insight into how we make markets in these products, from pricing the ETFs to managing our risk and delivering the ETF shares.

As a European market maker, we provide prices both on-exchange and over the phone to clients throughout European trading hours. As many of the emerging markets are closed during this time, our challenge is to provide investors with competitive prices in ETFs based on indices whose underlying components are shut.

We use modelling techniques based on a variety of correlated instruments to derive a ‘fair value’ for an ETF at any given time, which is essentially an attempt to estimate where we will be able to trade the underlyings when they open.

The instruments we use include a variety of derivatives, equities, bonds, currencies and in some cases commodities. Some investors may look at an intraday net asset value (iNAV) calculation to get an idea of fair value, but that is generally not an accurate reflection of the real-time net asset value (NAV) because the iNAV often uses the previous closing prices of the underlyings without factoring in any market moves since that time.

When we sell shares in an ETF, we often settle the trade from existing long inventory. In cases where we do not have inventory, we need to cover the trade by acquiring ETF shares. This is done either by placing a creation with the issuer for new shares or by buying shares on exchange (or off-exchange from other counterparties). We can also borrow the ETF shares, although borrowing shares in emerging market ETFs is neither easy nor inexpensive (albeit the ETF borrow market in Europe is improving).

Both methods of acquiring shares (creating and buying on- or off-exchange), can take time. For example a creation order placed today in an ETF with Asian components will not have a confirmed price until two days’  time (the Asian components will be traded the next morning, the currency struck the following afternoon and the official price published the morning after that).

We need to hedge our position during this time lag. Exact hedges for emerging market ETFs rarely exist, so in reality we have exposure to the trade until we acquire the actual ETF shares. (The same basic principles apply when we buy shares and need to divest of the position). This leads to a certain amount of variance for us. Our ability to handle this variance is an integral part of our ability to make competitive prices in these products.

Creating ETF shares in emerging markets can also be expensive (in some cases over 2% fees), so we will try to achieve two-way flow in ETFs in order to buy shares on exchange (or from other counterparties) instead of always creating. If we can cover trades in this cost effective manner, we can in turn provide tighter bid/offer spreads for investors.