ETFs are transparent. Investors know what they hold and the prices are updated throughout the trading day. They are cheaper than mutual funds and also more transparent.

That sounds like a free lunch, since many mutual funds are closet indexers.

But it’s not entirely a free lunch—investors are sharing part of it with the market-makers.

Market-makers (or authorized participants) represent up to 50% of the daily trading in ETFs. Their role is to keep the net asset value of the ETF in line with the value of the underlying stocks represented by the ETFs.

They do that for a price – “subpenny arbitrage profits” as Ed Boyd, managing director of RBC Capital Markets, commented recently at an ETF symposium in Toronto sponsored by Radius Financial Education. “The market has become fiercely competitive. We’re picking up pennies. We’re picking up parts of pennies on the train tracks all day.”

How does that work?

Part of it is the arbitrage between the ETF and the underlying basket of stocks. But part of it is that market-makers compete for order flow. Says Ian Williams, a managing director at ITG Group Canada: “ETFs have greater liquidity and that’s a function of the competition for that order flow. The most liquid ETFs have not just the most market-makers but also the arbitrageurs that are competing to access order flow.”

As a result, he says, “The pure market-maker, we provide the goal posts for the arbitrageurs who can arbitrage that with a high degree of risk-free profit.”

The cheap lunch for investors? It’s that they don’t have to buy all the underlying stocks, and thus avoid the commissions, stamp taxes, and currency transactions that market-makers and arbitrageurs undergo.

Or, says Williams: “I wouldn’t characterize it as a free lunch. What you have is access to asset classes that you didn’t have before and you have the opportunity for institutional pricing. The average costs for investors before were punitive.”

Scot Blythe is a Toronto-based financial writer.
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