On the Money with Dynamic Funds

PARTICIPANTS

Peter Tomiuk
Vice President of ETF Distribution, Dynamic Funds

Alan Green
Vice President and Head of ETFs, Dynamic Funds

Alex Perel
Director, Head ETF Services, Scotiabank

Speaker: You're listening to ETF Exchange, brought to you by On the Money with Dynamic Funds. Join us to learn about the latest investment trends and strategies to help you navigate the ever-changing ETF landscape.

Peter Tomiuk: Welcome to ETF Exchange, presented by On The Money with Dynamic Funds. This series will explore the world of exchange-traded funds, where we break down complex financial concepts into easy-to-understand discussions. Join us as we dive into the latest trends, investment strategies to help you navigate the ever-evolving landscape of ETFs. Whether you're a seasoned investor or just getting started, our goal is to provide valuable insights to help you make informed decisions and grow your wealth. Subscribe now for a deep dive into the exciting world of ETFs.

Alan Green: Hello everyone and welcome to the ETF Exchange. I'm Alan Green, your co-host.

Peter: Hello everyone, my name is Peter Tomiuk, your other co-host. I'm delighted to be back with you.

Alan: This time on the ETF Exchange, we have Alex Perel. Alex heads up Scotiabank's ETF market-making desk, which is part of Scotiabank's Capital Markets division.

Peter: Today we're going to discuss the role of the ETF market maker and Alex's place in the ETF ecosystem. We'll also help our listeners understand what a market maker does while discussing best practices in ETF trading. Alan, I believe you've been looking forward to this discussion.

Alan: That's right, Peter. I was really looking forward to being with you today. It's a subject that's very close to my heart. I started my career as an ETF market maker in the early 2000s. As you know, I often refer to myself as a recovering market maker, a recovering broker. Honestly, I don't think we'll ever be able to do without them. Back then, ETFs were in their infancy. I look forward to talking to Alex about how things have changed over the past 20 years, and what that means for our listeners and customers. I'd also like our listeners to really understand what the role of a market maker is, as I think it's often misunderstood. This will be a great conversation.

Peter: Okay. Alex, please introduce yourself to our listeners and tell them a little about your background.

Alex Perel: Of course. I'm head of ETF market making at Scotiabank. Like you, Alan, I picked up my computer and I'm a technophile, I think that’s the best way to describe me. My first love was computers, and I fell into the world of trading almost by accident, which is somewhat fortuitous because I work in a sector of the financial markets that is highly computerized and quite technical. Alan, just as the stockbroker never leaves you, neither does the love of technology and making computers work for me. That's about it as far as I'm concerned. I started out as a modest work-study student. The market and everything about it has certainly changed.

Alan: We'll probably get into technology and computers in a second, but maybe we'll start with some general questions. I'd love it if you could explain what a market maker is, maybe starting with what a stock or individual stock market maker is, and maybe how ETF market makers are different.

Alex: Whenever we get into the jargon and talk about fancy words like market making, there are a bunch of things that are actually pretty basic about it. When we talk about a market and what it means to access it, at the end of the day, what investors need is someone to trade against or with when they want to buy or sell something. In normal everyday life, this is pretty obvious. You go to a car dealership to buy a car, and the dealership sells you the car.

For financial assets, it's a little more abstract, but you still need someone to be on the other side of buying a stock, an ETF, an option, et cetera. In the stock world, the situation is a little different, because the common stock market is really about a bunch of investors in a company who have their own priorities as to what they want to do and when. One person may want to buy, and another may want to sell. The role of market-making is to bridge the gap between these investors so that when you want to do something, you have the possibility of trading with someone.

The ETF world is a little different because, for lack of a better term, it's not an investment per se, but a collection of investments. It's a box containing items. The way ETFs are traded, and this is beneficial to investors, is that you look inside the box and say, "What are the components inside? How much are they worth in total?" That should be the value of the whole container, the whole box. The role of market makers, which is both somewhat the same and somewhat different, is to provide a mechanism for investors to buy or sell ETFs, and again I use the word "always", but we'll get to that later.

What they're doing is they're dealing with someone who can reconstitute the ETF from these components, or take the ETF and break it down into its components and act as a bridge between the underlying assets and the ETF itself. Without going into too much detail, this creates an environment in which, regardless of whether other investors want to participate in that ETF, there is always the possibility of having a counterparty, someone to trade against.

Peter: Thank you very much, Alex. I'd like to know a little more about that. It sounds like you do a lot of calculations and work to make sure the ETF trades in line with the value of the securities in it. How do you do that? What does the technology look like, and how much of it is automated?

Alex: That's a good question. We try to automate as much as possible, but basically, the first step is to know what's inside. Every day, ETF issuers provide us with information on the Bell, TELUS, and Tesla shares they hold, as well as the bonds they hold. We feed all this into an infrastructure kit that generates, to the best of our ability, current market prices for all these underlying assets, and then we say, "Okay, well, how much is the total worth?" This calculation then feeds into a trading system that updates itself in real-time, frequently and constantly, and it says, "Okay, based on what I think is the intrinsic value of this ETF, let's say it's $10 to buy and $10.01 to sell, I can send orders to an exchange that stands ready to buy and sell this ETF to any investor at any time." We continually update these orders and adjust the price. This means we don't have to wait for an investor to show up. We're always ready. When an investor comes into the market and says, "I want to buy units of--" whatever the ETF---

Peter, to be a little more practical, what's your favorite dynamic ETF?

Peter: Alex, I'd say DXQ.

Alex: Okay. Let's talk about DXQ. DXQ holds a basket of mostly technology stocks, as well as options on those stocks. Our systems monitor the market prices for each of these components in real-time and continually update what we believe to be the value of the underlying assets in real-time. They will then send orders to the "stock exchange" - but in reality, it's several markets in Canada, because Canada is obviously complex - and stand ready to buy from investors or sell DXQ units to them. When Peter decides to sell, he will send an order through his iTrade platform to buy DXQ. This order will meet our ready and pending orders in the market. Peter will become an investor in DXQ and we will become short sellers. It seems intuitively obvious, but then again, sometimes people don't think about it.

Every time there's a trade on an ETF against the market maker, the latter is in a sense a disinvestor, for lack of a better term, because we've now sold the asset. He then buys the underlying shares and the equity equivalent of the options, in this case, to make sure his market risk is managed. This mechanism is sometimes referred to as ETF arbitrage. I don't know if I like the term, because arbitrage implies that there is no risk, when in fact we take market risk all the time. We just take it in small doses.

Alan: Going back to some of the terms you talked about, you talked about DXQ, which contains North American stocks and options, and you calculated what they're worth in real-time. I believe you used the example of $10 versus $10.01 earlier. How do investors know that this is the best possible price, or the fair price as it’s called in the industry? How do customers think about it, and how do they view it?

Alex: The short answer is that, in the absence of an infrastructure equivalent to the one we have, there's no way to do it. The longer answer is that the ETF market is not driven by a single market maker who decides where things are going. In fact, there are several market makers for the vast majority of Canadian ETFs. It's a very competitive space. If the prices weren't representative of the underlying assets, there would be an opportunity for real arbitrage, or risk-free arbitrage as it's called, where a market maker would say, "Well, this person is wrong, and I'm going to buy their mispriced ETF." Eventually, the situation would correct itself, so to speak.

It takes a leap of faith to believe that this mechanism works. As someone who works in this market every day, I can tell you, Alan, that my main fear in life is that we'll misprice something because we'll be learning about it from our competitors’ actions very, very quickly.

For ordinary investors, it's a bit more difficult. One of the things that confuse people is that we use terms like "Premium to Net Asset Value", "Net Asset Value" and all sorts of other terms. In reality, all these terms are a little misleading, because when you think about the value of an asset, you have to take into account the fact that you're entering a competitive environment where the people you're interacting with are all competing with each other. It's a bit like buying a car. You go to a dealership and think, "That Honda costs $22,000. Then you look around and wonder how much similar cars cost. If $22,000 is a reasonable price and people in the market generally agree, then it's probably the right price. It's a fair price. It doesn't matter that this Honda was worth $26,000 a year ago, it's worth $22,000 today.

I know that's not a very satisfactory answer because it would be nice to know definitively, but in reality, it's also a difficult thing, because these things are priced in real-time. These prices are set with a certain degree of uncertainty. You have to take a leap of faith and trust the mechanism and the process.

Alan: You've been in the business for almost 20 years, and you just mentioned how competitive the ETF market is today. Do you think things have changed much over time?

Alex: When I started working in the ETF industry, there were maybe a dozen products in Canada. A handful of companies were involved in ETF market making, and they didn't necessarily take it seriously as an essential part of their business. The level of investment was significant, but we weren't where we are today in terms of technological sophistication. The ETF industry has exploded in size, popularity, and relative importance to the investment community. Brokers, and I work for one of them, have invested significantly in the infrastructure that allows us to support this ecosystem. The ETF industry has become more efficient and more competitive. For me, it's more stimulating. It's certainly improved the overall investor experience.

Alan: Let's talk a bit about money and maybe how you make money as market makers. I think this topic is sometimes misunderstood. How do you make money as a market maker, and has this compensation evolved over the years?

Alex: Yes, the way we make money in this business, at the end of the day, is that it's a risky business. We have to take risks on every transaction, and we do it in small chunks. For the market to be efficient and for investors to have a good experience, you can't have a world where people overpay all the time. Systemically, all we do is charge a rent, essentially. What happens is, like in our previous example, Peter decided that his kids, our ESP, should all be in DXQ, what happens is we sell that DXQ to Peter, and then the systems have to make a decision. Should I buy the underlying basket of shares and option equivalents right away, or wait? I might try to get a slightly better price by taking a little risk in the market for the next 2 minutes, 5 minutes, 10 minutes, or an hour. It's certainly not days. It's certainly not, in our case, hours. Rather, it's a process that looks at all the orders we handle, all the ETF flows we handle, and how we manage residual market risk in the least onerous way possible. If we do it with enough sophistication, we have the opportunity to make some money. It's a very competitive, very low-margin business that's partly there to make sure that everybody in the asset management community we're involved in as a service provider, succeeds. We essentially operate as a low-margin utility business that nevertheless has to support other parts of the ecosystem and the bank, and then the direct investment community and all the things that investors depend on.

Peter: ETFs cover a wide range of asset classes, from equities to bonds, commodities, real assets, et cetera. How do you adapt your market-making techniques to the different types of ETFs?

Alex: You could say that there's a range of things that are very easy to evaluate and very precise and others that are much more uncertain. For example, probably the easiest thing to evaluate is something that holds the early fixed-income instruments which are cash management and money market-type vehicles. These instruments exist and their value is known at all times. It is possible to approach these instruments with this level of precision.

Secondly, the products that are most difficult to evaluate, hedge, and manage are generally equity products, for which market prices are observable and which are directly exposed to share price movements, and therefore to company news and much of what I would call idiosyncratic risk.

These products tend to be reasonably easy to price in concept, but they are highly dependent on technology, how quickly you can get price updates, and how quickly your systems can hedge the risk as you see fit.

Corporate bonds are a good example. Corporate bonds are a very deep but not very transparent market, it's an institutional market that certainly has a lot of competition but it has a lot of nuance in the way quotes are published. One of the main differences with bonds is that the bond community talks about yield. They don't talk about the price of bonds, they just say that such and such a bond yields such and such, and such and such a bond yields a little more or maybe a little less. The price depends on the bond's yield, coupon, maturity, and all the other features of the bond.

In the ETF world, it's the other way around. In the ETF world, you ask yourself, how much is this stock worth today? How much can I buy it for in dollars? Yield is a consequence. When it comes to fixed income, we have to transform our brains by taking a portfolio of bonds held in an ETF and looking at interest rate sensitivity or credit sensitivity in the event of default by some of the issuers of the bonds you might hold in that portfolio. How does it change today? Next, we need to convert the type of information that the bond market processes into ETF terms. We end up with a portfolio of ETFs that we think of as a bond portfolio. We hold several bonds that cover this ETF portfolio. We wonder how much interest-rate sensitivity we have left. We manage that.

It's a completely different story from our DXQ example, where Peter buys DXQ, and then we buy Nvidia, Tesla, and other stocks. In the case of a fixed-income fund, we'll say, “Okay, we've sold exposure to 5-year government bonds and some of the credit component around that point on the curve.” What we'll do is manage all the interest-rate risk we have left. That's quite different. When it comes to commodities, a lot of what we do is manage the role of one futures contract in the next futures contract, and you're dealing with the intricacies of how these products are ultimately implemented. Indeed, in most cases, the ETF isn't going to hold pieces of copper or barrels of oil. They will hold financial instruments that give exposure to barrels of oil or pieces of copper, I suppose. This means we have to be experts on how that works and how these financial product markets give exposure to commodities, that is, how they work. It's quite different.

Alan: We mentioned in the introduction that we wanted to discuss best trading practices for our auditors. What best practices would you recommend?

Alex: I think a lot of investors are concerned about liquidity and are interested in volume. The first thing I would suggest in ETFs because we've talked about arbitrage, market making, or other related concepts, is that there can be some reluctance about trading volume. Here's what trading volume means. It means that on that day, investors traded a certain number of shares. It says nothing at all about the potential liquidity of that asset class, that ETF, or anything else you might do that day. If nobody wants to buy that Honda from the dealer, it doesn't mean the Honda isn't for sale. The first trading tip would be to ignore volume altogether and focus on how the product fits into your portfolio, how it helps you achieve your investment goals, plan for your retirement or your children's education, whatever it may be.

The second tip is to put yourself in the shoes of the market makers and say to yourself, "If the market is more volatile or momentarily more volatile, it's probably not a good time to look for a counterparty." The most obvious examples are the opening market and the closing market. The opening market is a little more common. It's a situation where, for stocks in particular, the market makers don't really know where the stocks are going to open and there's no real mechanism to know where an ETF should open at the same time and price as the underlying stocks.

My advice to people is not to place orders overnight and trade them at the next day's opening. This kind of operation only places you in a vulnerable position. You can't rely on the market-making strategy to work if the market makers can't be precise about their prices and the evolution of the underlying asset class.

By extension, sometimes the Canadian market is open, and therefore Canadian ETFs are traded, but the underlying asset is not open. The most obvious example is on July 4, or any other U.S. holiday when Canada is open. If the U.S. stock market isn't open, there's no reason to think that anyone in Canada knows where U.S. stocks should be trading, at what prices they should be trading, and, therefore, what the fair prices are for the ETF. In this case, if you can wait a day, wait a day. On average, you'll be better off.

Lastly, investors tend to place their orders in two ways. They place market orders and limit orders. Market orders mean that when the order goes through the execution pipeline, what you see is what you get, what you get is what you get. If you're a little bigger than what's quoted on the market, you risk getting a price that doesn't suit you. Limit orders are often seen as a way of guarding against this risk, but I would add that there is a way of misusing them. If supply and demand for an ETF are, say, 10 to 10.01, that means that if you place a limit of $10, you have to wait for someone to sell you the stock at $10. There are two possibilities. An existing investor can appear out of nowhere and sell to you at $10, and that's fine. What's more likely to happen is that you stay at $10 and the market makers wait and wait and wait, and when the underlying assets are worth less than $10, they sell them to you at $10. I don't think that's an outcome people want.

In my opinion, the right way to use limit orders when you're trying to move your portfolio is to set your limit at the opposite end of the market. In our example, 10.01, or perhaps a penny more. This will make your order immediately actionable. Your order will be protected against an unfortunate situation where, for one reason or another, you get a lower price than you expected. This will help you understand how much cash is involved in the execution on your end.

Alan: Thanks, Alex. First of all, it's been a great conversation. I like the analogy you made: market makers are the wheel in the ecosystem that connects buyers and sellers and maintains the ETF at its intrinsic value or fair value. I also think we've rounded out this conversation with some good trading advice. On that note, thanks again to Alex and Peter, and we'll be back soon for another episode of ETF Exchange by Dynamic Funds. Thank you all very much.

Speaker: This audio was prepared by 1832 Asset Management LP and is provided for informational purposes only. Opinions expressed regarding a particular investment, economy, industry, or market sector should not be taken as an indication of trading intentions for any of the mutual funds managed by 1832 Asset Management LP. These opinions should not be considered investment advice, nor as a recommendation to buy or sell. These opinions are subject to change at any time based on market and other conditions, and we disclaim any responsibility to update these opinions. Any information or data contained in this audio obtained from third-party sources is believed to be accurate and reliable as of the date of publication. 1832 Asset Management LP does not guarantee their accuracy or reliability. Nothing in this document is or should be considered a promise or representation as to the future. Commissions, trailing commissions, management fees, and expenses all may be associated with mutual fund and ETF investments. Please read the prospectus before investing. The indicated rates of return are the historical annual compounded total returns including changes in unit value. Reinvestment of all distributions does not take into account sales, redemptions, or option changes, nor income taxes payable by any security holder that would have reduced returns. Mutual funds and exchange-traded funds are not guaranteed. Their values change frequently and past performance may not be repeated.