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How Mistakes and Discoveries Led ETFs to Reshape Capital Markets


As of 2022, there were 8,754 ETFs worldwide. That may seem small compared to the current world population of over 8 billion people, but in fact, the number of available ETFs grew exponentially since 2003 – when there were only 276.

And those nearly 9,000 ETFs hold a combined value of almost USD $10 trillion in managed assets.

In other words, ETFs are not to be underestimated in today’s market. But how much do you know about them really?

Although they debuted in the early 1990s, it took some time for their presence to not only be known, but smartly taken advantage of.

Nicole Hunter, Head of ETF Capital Markets at Dimensional Fund Advisors and Ugo Egbunike, Fixed Income Specialist at Jane Street sat down with Morningstar’s Big Picture in Practice podcast to share their experiences and insights on how ETFs have evolved and shaped our market as we know it today.

You can listen to this and other episodes of the Big Picture in Practice podcast by Morningstar on all major streaming platforms. You can keep up with the latest episodes by subscribing to our Big Picture in Practice Newsletter.

What exactly is the ETF capital market, and how do people work with ETFs day-to-day?

According to Nicole, this is the most popular question she and DFA get when someone hears the term “ETF.”

An ETF stands for “exchange-traded fund,” and it pools investment opportunities much like a mutual fund. However, unlike a mutual fund, ETFs can be purchased or sold on a stock exchange just like a regular stock.

“Today we call it ETF capital markets, but really, it's all the things that were in a traditional mutual fund shop. And over the years, the industry has evolved. And now we have what we call the ETF Capital Markets team,” Nicole says.

What does someone in ETF capital markets do on a day-to-day basis and what’s changed over the years, exactly?

For someone working with ETFs, Nicole breaks down a day-in-the-life into three segments at DFA:

  • Broker-dealer services.
  • Client execution services.
  • Engaging the ETF industry.

Broker-dealer services
“I'd like to break it down into three different segments, the first being what I call broker-dealer services,” Nicole shares. “Unlike a typical mutual fund where clients can interact directly with the fund to buy and sell shares, with ETFs, you can't. Only those authorized participants and those broker-dealers who are contracted, can.

“On a day-to-day basis, they require a certain level of service to make sure they can effectively and efficiently engage with each ETF and each issuer. At DFA, that's what our team primarily does, is make sure that markets around the ETFs are efficient.”

Client execution services
Even the most enthusiastic investor may still have to pump the brakes before diving in. Why?

According to Nicole, many of them have never traded a stock or ETF before. There’s a lot they have to understand before execution.

“We have a lot of clients, and it amazes me that even after this many years into the ETF industry, that there are still a lot of new entrants who've never traded a stock or an ETF before,” says Nicole. “They have a lot of questions about best execution. There's this level of service to help them understand things that they should consider like the tradeoffs of coming in and out of any ETF across different asset classes.”

Engaging the ETF industry
Investment opportunities are constantly evolving, as are the regulations that surround them. For people like Nicole and Ugo, there’s a regular responsibility to engage with the industry to keep up with news of regulation updates, market trends, and other information that an ETF user needs to know.

"There are a lot of new ETF regulations and there's a lot of things still going on. So, in this space continually to be connected, and kind of what's coming next for the industry are three of the main functions of the ETF cap markets, how we spend our time, day to day. Connecting the dots across these three areas and connecting with people who like talking about ETFs.”

What’s changed about ETFs over the years?

“It’s a new lane.”

That’s how both Nicole and Ugo describe what ETFs are nowadays. What do they mean? There’s more choice, and more accessibility.

“I think the thing that is very different is the choice for investors before were predominantly passive ETFs. But I think the investors have a better choice now today, especially with DFA offering really a new lane, where it's the best of active and passive,” says Nicole.

For example, DFA offers 34 products that have broadly diversified low cost, low turnover, but also married with that flexible, active approach is something new with ETFs in today’s industry. And alongside that, the clients of advisors and asset managers themselves are also playing a bigger part in the trades.

“The types of investors who are doing ETFs are also changing,” notes Ugo. “The industry has changed and where you're starting to see not only more entrenched, traditional asset managers come into the space, but also the types of folks that are trading ETFs are starting to change.”

How have ETFs re-shaped capital markets?

Once upon a time, there were no fixed-income ETFs. And you fast forward to today, and there are ETFs that offer actively managed carbon strategies, and even more niche exposures to segments of fixed-income markets.

It’s been roughly 30-odd years since ETFs were introduced. What are the biggest changes from then to now?

In a word, “access.”

“For clients, it's that they have more access and they're getting better quality choices,” Nicole says. “Fifteen years ago, asset classes were very siloed. And a lot of the sell-side firms didn't always integrate across asset classes. And I think we've seen that evolution before where a client comes in, and they're going to build a portfolio that may include both fixed income and equity, and they want their broker to be able to price them across different asset classes.”

ETFs have forced a lot of that brokerage technology and other things to evolve and become more client friendly. And the end result is more efficient markets across asset classes, not to mention a well-supported ecosystem to this new active ETF line.

And according to Ugo, this level of access is not only one of the biggest ETF evolutions, but also a major benefit of packaging investment strategies.

“It's one thing to build it, it's another thing to make sure it works out in the marketplace. And that's where partners like Jane Street are important – we make sure that products are ready to rebalance and that there’s sufficient liquidity when clients are ready,“ Ugo says.

“One of the biggest advantages I would say is having immediate access to liquidity, where you have intraday liquidity as opposed to end of day liquidity. And then certainly from a tax perspective, when you look at how capital gains are able to be better managed within the ETF wrapper via iterations and redemptions,” Ugo adds.

What are the most common (and avoidable) mistakes you see when it comes to ETF trading?

According to Nicole, one of the most important things to their ETF clients is price, followed closely by putting the trade through. But ironically, one of the most common mistakes emphasized by both Ugo and Nicole is allowing unlimited funds to be used in their trades. When this happens, you risk your execution costs surpassing and eating into the potential long-term performance of the investment.

“A very common mistake that we've seen is sort of the use of market orders, particularly for newer ETFs, and the overall composition of an ETF basket,” shares Ugo. “If you think about it from our perspective, as a market maker, we spend a lot of time figuring out the composition of an ETF basket—how we should price it, how we should arrive at what's the fair value of that ETF should look like on a real time basis. And then we're making markets around that fair value.”

I would definitely caution newer investors to set a limit at the end of the day. I think it's in the best interest of investors to set a limit order when they're trading in and out of funds.

- Ugo Egbunike

This is why both Nicole and Ugo stress the helpfulness of expert eyes on ETFs to avoid losing unnecessary money on an investment.

“We kind of walk them through the life of their trade, to make sure that their priority of price over time is achieved. And that can be new to a lot of folks,” observes Nicole. “But like Ugo said, it's the market orders, and an ETF that doesn't have a lot of liquidity, that kind of keeps me up at night, because it can move the price around. And that would eat into, like Ugo also said, the long-term performance.”

The bottom line of ETF capital markets

Ugo and Nicole both agree on one main bottom line:

Investors need to thoroughly consider their investment options, and the choices they’re making. And not do it alone; asset managers and advisors are there to help wade through research and implementation.

“Clients are voting with their dollars and they're building robust portfolios with active ETFs that are broadly diversified at a low cost," Nicole advises. “I think there's a lot to be said about that. And when you think about the rise of just the overall active ETF space, it's undeniable. I think investors really need to think about the choices that they have out there and look to an asset manager that is going to be doing the due diligence from product development, all the way through implementation.

“In a lot of ways, the ETF wrapper has given investors not only better access to strategies, but has also basically put trading within their hands,” Ugo notes. “So, I would stress that it's important for both small and large institutional investors to just spend some time thinking about their execution strategy after they’ve made an ETF investment decision.”

What should investors do to get this support? Ask for help!

Reach out to liquidity providers, to their respective capital market staff, and to people like Nicole at DFA to get the support that makes sense for you and leads to a better understanding of what your trade execution should look like.

“It's always better to be redundant, to some extent in terms of communication, than to miss something. And that affects your performance as a result,” Ugo says.

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