Yield of Dreams

Lesson Learned From Knight: Be Careful of Small, Illiquid ETFs

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News of market marker Knight Capital’s trading blunder has dominated the headlines the last couple days, causing many to speculate whether the firm will survive. One lesson coming out of the debacle: Avoid small, illiquid ETFs—at least for now.

Wednesday morning, a computer glitch in Knight’s trading software caused numerous erroneous orders of NYSE-listed stocks into the market. The glitch resulted in a $440 million loss for the firm.  

According to a report by Index Universe, average spreads on ETFs that normally trade less than 50,000 shares a day grew from 56 basis points to 94 percent in the days following Knight’s troubles. Even worse, average spreads rose from 0.49 percent to 1.53 percent for illiquid ETFs with volume of less than 50,000 for which Knight is the lead market maker. Dave Nadig, Index Universe’s director of research, says:

What does this mean for investors? It means if ever there were a time to tread carefully into illiquid ETFs, now’s that time.

Knight is the largest player in this corner of the market, providing liquidity as the lead market maker (LMM) for some 150 low-volume ETFs. LMMs make a commitment to the New York Stock Exchange to maintain constant quoting on ETFs, and in many of these less liquid ETFs, the LMM will be the only market maker quoting on a regular basis.

While I don’t know which of these ETFs are illiquid or low-volume, you can find a list of NYSE-listed ETFs and their lead market makers by clicking here. According to the document, Knight is the lead market maker for a total of 335 ETFs.

I think the Knight incident will cause a ripple through the ETF industry. How big a ripple? We don't know at this point. But it's definitely something to look out for in client portfolios.

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Casting a gimlet-eye on asset management issues.

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