Why Market Makers Quote New ETF Launches Differently From Conversions

How Investor Flows Shape ETF Pricing

When an ETF begins trading, investors generally focus on its investment strategy, expense ratio, and starting assets. But from a market maker's perspective, another consideration can be just as important: Who is likely to buy or sell the fund?

The answer can be quite different for a newly launched ETF compared with a mutual fund converting into an ETF. Those differences can influence where market makers position their bids and offers relative to the fund's estimated fair value.

New Launches: Expecting Buyers

Most newly launched ETFs begin with a relatively small shareholder base, often consisting primarily of seed investors. Since there are few existing shareholders looking to exit, initial trading activity is generally expected to come from buyers.

Short selling is also less common in a new ETF, particularly when shares are difficult to borrow and there is limited trading activity.

Knowing this, a market maker may position both its bid and offer above estimated fair value, anticipating that incoming investors will primarily be buying shares.

For example, if a fund's estimated fair value is $25.00, a market maker might quote $25.02 bid and $25.08 offered rather than positioning its market evenly around $25.00.

I remember a similar dynamic from early in my ETF market-making career when I was trading EFA. There was persistent buying demand and very little natural selling. We were creating shares almost every week to satisfy that demand, yet we routinely positioned our bids above estimated fair value and our offers above creation cost. Even with a functioning creation mechanism, the lack of sellers had a meaningful influence on where we quoted the market.

However, there are limits to this approach. If the bid becomes too aggressive relative to fair value, professional traders may sell into it. The ETF creation and redemption mechanism also provides an important economic constraint on pricing deviations, although transaction costs and hedging risks influence how effective that mechanism can be.

Conversions: A Different Starting Point

A mutual fund converting into an ETF may begin trading with hundreds of millions of dollars in assets and an established shareholder base.

Unlike a new launch, some of those shareholders may want to sell immediately, while others may continue holding or add to their positions. This creates the possibility of meaningful two-way order flow from the outset.

A market maker anticipating both buyers and sellers may initially position its bid below fair value and its offer above it, rather than leaning the entire market upward.

For a fund with an estimated fair value of $25.00, that might mean quoting $24.97 bid and $25.03 offered.

Of course, these are only illustrative examples. If selling pressure develops, market makers may adjust their quotes lower. If buyers dominate, they may move their markets higher.

A market maker anticipating two-way order flow may initially quote around fair value, but that doesn't necessarily mean the spread will be tight. The bid may reflect redemption economics, while the offer incorporates creation costs, including cash-in-lieu exposures, variable fees, and other transaction expenses. However, as consistent buying and selling activity develops, the market maker may become comfortable quoting inside those primary-market cost levels, since offsetting trades can reduce the need to create or redeem shares.

The important distinction is that starting assets do not necessarily determine how an ETF trades. The direction and composition of order flow can be more influential.

The Underlying Asset Class Matters

These differences become even more interesting when the ETF holds international equities, fixed income, or other assets that may be difficult to price or hedge.

Consider two international equity ETFs with similar underlying exposures.

An established ETF with significant institutional participation may trade at a discount to its last published NAV because professional traders anticipate that the underlying foreign markets will open lower.

Meanwhile, a newly launched ETF holding similar securities may experience predominantly buy-side demand and relatively little participation from professional traders. Its market could therefore remain closer to its published NAV, or even trade at a premium.

This does not mean the new fund's underlying securities are worth more. It reflects differences in market participation, expected order flow, and the way market makers position their quotes.

Market makers may also use established ETFs, futures, or other correlated instruments to hedge their exposure. The availability and effectiveness of those hedges can influence how aggressively they quote either fund.

Fair Value Is the Starting Point, Not Necessarily the Midpoint

ETF market makers continuously estimate the value of a fund's underlying exposure. But that estimate does not automatically become the midpoint of their bid and offer.

Market makers must also consider inventory, expected trading activity, hedging costs, underlying liquidity, and competition from other participants.

The creation and redemption mechanism generally helps keep ETF prices aligned with the economic value of their underlying holdings. However, it does not eliminate the smaller pricing differences that can develop from these considerations.

Two ETFs with nearly identical portfolios can trade differently simply because their shareholder bases and order-flow characteristics are different.

For ETF issuers, understanding this distinction is particularly important when preparing for a new launch or mutual fund conversion. A successful opening isn't just about having the right portfolio and operational infrastructure. It's also about understanding how market makers are likely to approach the fund's first days of trading.

Disclaimer

Please note this article is for information purposes only and does not in any way constitute investment advice. It is essential that you seek advice from a registered financial professional prior to making any investment decision.