How Market Makers Profit on ETFs

Investors should be aware that this situation applies to all ETFs, not just those of the leveraged variety. High-speed arbitrage traders can make tidy products in both highly liquid and illiquid products. The Financial Select Sector SPDR (XLF) has an average daily trading volume of nearly 150 million shares. Since this ETF is so liquid, the spread -- the difference between the bid and ask -- is generally a penny. If a high-frequency trading firm is able to dominate the spread and lock in a penny a trade, the profits add up quick.

In illiquid ETFs, the lead market maker may be the only buyer and seller around. This means that retail investors may have to pay a premium to buy shares and sell their investments at a discount. If a market maker can lock in a hefty spread in relatively illiquid products, they pay for themselves.

Is high-frequency trading bad for ETF investors? In most cases, it's not. High-frequency traders provide liquidity in many popular funds, and the competition for order flow can minimize the spread between the price and the net asset value. The debate hinges on whether traders can manipulate commodities through the use of indexing strategies like ETFs, but in the case of most traditional ETFs, this is a non-issue. Liquidity can flow from new technology, and high-frequency trading can make ETFs leaner.

-- Written by Don Dion in Williamstown, Mass. .

>To order reprints of this article, click here: Reprints