Many ETFs come out as illiquid because they invest in illiquid securities, such as foreign or exotic markets. In those cases, the specialists have to take a lot of risk to make markets every day because some stocks may trade only once a week. That’s why they need a fairly wide bid/ask to take on the underlying illiquidity risk. Kellogg, on the other hand, can offset a large order in the Treasury market within a basis point or two. That’s why they are able to give a tighter market to the investors.

Q:  Could you explain to our readers the dynamics of the ETF market?

A: A few years ago, when there were just a handful of ETFs, it was not unusual to see a specialist to provide $40 or $60 million dollars into an ETF on the first day of trading. In essence, the specialist was funding the ETF and making it profitable on day one. That was a very nice business model for the fund sponsors. Because the ETFs were new and exciting for investors, the specialists could sell their positions fairly quickly and there was a good spread.

Now investors are much more comfortable trading the ETFs and the spreads have narrowed down. You can buy them not just on the NYSE or the AMEX, but also on ECN markets like BAT and Archipelago. The spreads are very thin on the third-party markets and the trading is fast. Hedge funds are also using them for arbitrage between buying and selling the underlying security or buying one ETF and selling another.

So the opportunity for the specialists to profit has slowly declined in this competitive marketplace. Many of them have left the ETF business or have gone out of business. But because now there are fewer specialists, they can dictate the terms better. They start to lower the amount that they are willing to put in, and at the same time there are more ETFs. So the dynamics of the marketplace is quickly switching the power to the specialist. That means that you cannot just put the ETF on the wall and hope it sticks. You have to go out and sell it with a strong underlying economic reason for the investors.

I expect that now, when the specialists have the upper hand, other people will try to take that power away. We’ll start seeing the plan sponsor putting up money for the first trade, no longer relying on the specialist to provide liquidity. Or, we may find the sponsor bringing in financing from private equity groups, for example. In another scenario, it may be the trading desk funding the trade because they’re making a market and having inventory anyway, but they might get paid for this by the fund sponsor. If it’s a long term relationship, it may be part of the management fee. That’s where I expect the next evolution of the market.

Q:  Is the short-side dynamics substantially different?

A: No. The beauty of the ETFs is that, all of a sudden, bonds trade like stocks. Shorting a bond is not that easy for the average investor, but is quite easy with an ETF. Because we provide five different ETFs exactly along the yield curve, if the interest rates fluctuate as opposed to just going up or down, you can go long for the 20-year ETF and short the 1-year ETF. Therefore, you don’t really care if interest rates go up or down.

Because it is so easy to go long and short with ETFs, investors may play the yield curve, not just invest along the curve. The investors with a ladder strategy would not need to monitor the portfolio because we rebalance each time the next on-the-run security comes out. So they don’t have to worry about a 5-year bond becoming a 4, 3, 2 or 1-year bond. It stays at 5 years.