Some of the biggest exchange-traded funds now have bid-ask spreads lower than the underlying securities they hold.
There are multiple reasons, but a significant part of the answer is that these investment vehicles offer a more favorable investing alternative for the institutions that buy and sell them.
Perhaps the poster child for low spreads is State Street Global Advisors' behemoth SPDR S&P 500 ETF. It has a bid-ask spread of 0.01%, which is tighter even than General Electric Co. stock, which is a component of the underlying index.
Here are some key reasons why this phenomenon occurs.
Portfolio managers and other large investors use some large ETFs as hedging instruments. In doing so, the volume of shares traded increases and squeezes the spreads to far lower levels.
The obvious case is that investors use the SPDR S&P 500 to manage their price risk. In the past, portfolio managers had little choice but to pick products from the futures and options markets. Now they have a plethora of alternatives.
The SPDR isn't the only such ETF used in this way. SSGA's Financial Select Sector SPDR, Van Eck Associates Corp.'s VanEck Vectors Gold Miners, and Invesco PowerShares QQQ, all act as benchmarks for their market sectors: banking, gold mining and the tech-heavy Nasdaq top 100 stocks, respectively.
Other examples of ETFs acting as benchmarks that can be used to hedge risk include BlackRock Inc.'s iShares iBoxx $ High Yield Corp Bond, the SPDR Bloomberg Barclays High Yield Bond, and the iShares iBoxx $ Investment Grade Corp Bond, all for fixed income. All can and are used instead of derivatives for portfolio risk management.
"They become price discovery vehicles," said Stephen Sachs, global head of capital markets at Goldman Sachs Asset Management. "Very seldom does the underlying basket (of shares) actually trade; it is the authorized participants and other market makers and all the other people in the system who are trading."
In this instance, the underlying stocks sometimes play a subservient role.
"The instrument itself does take on a life of its own and becomes a price discovery vehicle," said Mr. Sachs.
ETFs can allow a large investor to take delivery of a slew of securities that might otherwise be hard or time-consuming, to obtain in a single transaction, which is particularly useful in the opaque and sometimes illiquid high-yield market.
"One very popular transaction is that institutions will acquire shares of a junk bond ETF, then redeem the shares with the authorized participant and take delivery of all the underlying securities," said Mr. Sachs. "The institutional community is very tuned into this."
This trade enables institutions to get the actual basket of bonds delivered using a single transaction. This can reduce the trading time and slim down back-office expenses.
"The ease of buying does really help streamline the efficiency for bond buying," said Mr. Sachs.
ETFs can create more demand for trading the so-called wrapper than there is in the underlying securities or assets.
Hedging does create more demand for some ETFs. But there are other ways to change the dynamics, particularly if the market for the underlying asset is esoteric, such as gold.
Traders new to precious metals will surely know that bullion markets can be notoriously illiquid depending on the time of day. Historically, accessing such markets typically meant either dealing with a futures broker, such as R.J. O'Brien & Associates LLC in Chicago or a bullion bank such as ScotiaMocatta, a division of Toronto-based Bank of Nova Scotia. Both the futures market and the bullion market have their ways of doing business, and neither is identical to the stock market.
The creation of the SPDR Gold Shares allowed investors to buy and sell gold just like they would a stock. It created more buyers and sellers, said William Rhind, CEO of ETF firm GraniteShares Inc. in New York.
Not only did the ETF open the market to many small investors, but it made it far easier for small institutions to access gold investments and reduced hassle for major financial firms. The back-office process for dealing with the gold trades doesn't require a different system for gold ETF shares than it does for other ETFs. That wasn't the case before the gold ETF.
Because ETFs hold a basket of securities, they can be less risky for the market makers to trade than doing the same for individual shares. "A basket of securities is always going to be less risky for market makers than single stocks," says Pravit Chintawongvanich, head of derivatives strategy at Macro Risk Advisors in New York. "This is by pure virtue that these things aren't 100% correlated."
