Sound of ETFs: Issuers and Market Makers – A Symbiotic Ecosystem

A Two-Way Street

A new, successful product launch requires aligned goals and expectations. LMMs aren’t one-size fits all and may not be a good match for every issuer. Whether that’s specializing in a particular asset class to focus on best-in-class sourcing of that sector or offering tight big-ask spreads compared to another, many LMMs have a variety of value adds that can benefit specific ETFs that may come to market. This competitive environment provides operational efficiencies for the ETF and investors.

The in-kind creation/redemption process is a major benefit to an ETF and can provide tax efficient portfolio management. An ETF’s LMM provides critical assistance when an ETF needs its portfolio rebalanced and wants to ensure a tax-efficient outcome. Active ETFs that rebalance frequently and utilize the custom-in-kind rebalance process rely on their capital markets relationships to provide necessary assistance.

There’s a common phrase, “You don’t know what you don’t know”. So, make sure you know, or know someone who does know the unique needs and challenges of the market making community. 

How do you get up to speed?  A good place to start is with an open dialogue at the source.

Collaboration is Key

A collaborative, transparent relationship between issuers and LMMs is a welcomed trend that exists within the ETF ecosystem. During early engagements, LMMs are becoming more willing to offer consultative conversations that focus on having the best system in place to create the desired outcome that fits all parties’ needs. Their perspective regarding what types of securities work best in an ETF to provide ETF share liquidity can be a great value add for first time managers who may have had experience in mutual funds. 

LMMs have an obligation to provide a specified market for an ETF during the trading day, but firms acting as LMM do not automatically take on the role for all ETFs. Issuers need to be prepared to have conversations with potential LMMs to find a willing counterpart. In addition to the ETF strategy, they will also be interested in the ETF issuer’s ability to market the product to create AUM and trading volume. These considerations, in conjunction with their own analysis, provide context for LMMs ability to offer a tight bid-ask spread.

The goal of the LMM is not to direct a portfolio manager’s strategy or choice universe of securities for an ETF. The goal of these initial conversations is to come to the most operationally efficient strategy and the most risk efficient way for the LMM to perform their role. Just like any healthy relationship, it takes work on both sides and a willingness to listen and seek ways to improve.

Enhancing the Partnership

Once the relationship is established, maintenance and enhancement are the next steps. Whether it’s discussing best practices for relying on the LMM to help with a custom rebalance or simply discussing the growth plans of the ETF issuer, setting expectations and continual communication are a fundamental element to a productive working relationship. 

LMMs appreciate open lines of communication for issues that require urgent answers. Specifically, their expertise can help ETF issuers and their clients understand how to handle large trades in the ETF that may come from key investors. Open communication can help all parties to see around corners for potential hiccups in the process and assist in delivering beneficial outcomes.

LMMs and capital markets groups are invested in the success of your product. They are looking for alignment on all aspects including marketing and distribution. Continue to use these groups as an extension of your internal operations so everyone involved has the most productive experience possible.

Fostering these lasting, productive Capital Markets relationships requires a final element, time. As both parties work through unique circumstances that may arise throughout the life of an ETF, the process ultimately improves, and relationships are solidified.

Working with experienced groups that have connections throughout the ETF ecosystem can bypass some barriers to entry, but always consider what is best for the ETF, the Capital Markets partners, and end investor.

About the Author

Dom Dalmaso, CFA, CAIA is the CIO and co-founder of Sound Capital Solutions – an Investment Adviser offering both White Label services and a unique Solutions Provider offering that provides clients with the tools to act as their own ETF Adviser.  He began his career in investment sales before his current role as the primary investment professional aiding in product development and management, complementing areas of expertise and knowledge with partners at Sound Capital Solutions. 

Disclaimer

Please note this article is for information purposes only and does not in any way constitute investment, legal, or tax advice. It is essential that you seek advice from a registered financial professional prior to making any investment decision. Sound Capital Solutions LLC is committed to adhering to the fiduciary standard, acting in the best interest of its clients at all times. As an RIA, we are obligated to disclose any potential conflicts of interest that may exist to our clients. Information about the firm’s services and fees can be found in the firm’s Form ADV which is available upon request or by visiting the SEC's Investment Adviser Public Disclosure (IAPD) website.”