What is a market maker?

Claymore Investments, Inc. 14 May, 2010 | 2:45AM

Unlike open-ended mutual funds, individual investors do not buy and sell shares directly with the ETF itself. Larger investors, also known as market makers or designated brokers (or "DBs"), are contracted to buy and sell directly from the ETF in exchange for baskets of the underlying securities held within the ETF. They in turn provide liquidity to the market by selling and buying the shares of the ETF to broader investors through the listed exchange.

The designated brokers ensure ETFs are liquid by letting investors buy and sell as many or as few ETF shares as they like at any time throughout the trading day at specific prices. Throughout the day (every 15 seconds in fact), the DB's computerized auto trader calculates the net asset value of the ETF, which allows them to make markets around this net asset value during the day.

The DB posts a bid and an ask on the market for the ETF shares based on the calculated NAV. The DB's bid price is the price they are willing to buy the ETF shares back from investors and is typically the NAV less the weighted-average bid-ask spread of the underlying basket of securities that are held within the ETF. The DB's ask price is the price they are willing to sell the ETF shares to the investors in the market and is typically the NAV plus the spread of the underlying baskets of the underlying stocks within the ETF as well. Hedging costs and other profit margins may also be built into the spread between the DB's bid and ask prices.

About Author

Claymore Investments, Inc.

Claymore Investments, Inc.