August 3, 2012 / 11:17 AM / 6 years ago

Investors in illiquid ETFs may get hurt by Knight debacle

NEW YORK (Reuters) - Retail investors and traders who want to buy and sell small, illiquid exchange-traded funds may be unwittingly losing money in the aftermath of the Knight Capital Group KCG.N trading disaster Wednesday, according to an analysis by IndexUniverse, a San Francisco-based ETF research provider.

Knight Capital is the biggest exchange-traded fund market maker, meaning that usually it steps in to make sure that the ETFs are priced in accordance with demand and provide liquidity.

For illiquid ETFs, or those ETFs that trade less than 50,000 shares per day, market makers like Knight make sure that trades get executed at prices within the bid and ask range.

But on Thursday, the day after Knight announced a trading glitch that cost the firm $440 million, the average spread for the 549 illiquid ETFs for which Knight acts as the lead market maker widened threefold.

The average spreads, or the difference between the bid and ask price of the ETFs, jumped from 0.49 percent in the two days before the trading glitch occurred to 1.53 percent on Wednesday and Thursday, according to research by IndexUniverse. On July 30 and 31 the average spread for those ETFs was 0.49 percent.

“If ever there was a time to stay away from illiquid ETFs, it’s now,” said Dave Nadig, director of research at IndexUniverse. “Some of these ETFs are trading at uninvestable highway-robbery spreads because Knight just wasn’t there to regulate the pricing of those ETFs.”

A call to Knight was not immediately returned.

Exchange-traded fund issuers, for which Knight is the lead market maker, have been calling competitors to make sure they can step in if Knight does not execute trades in their funds, according to two people familiar with the situation, who declined to be named because they were not authorized to comment.

Dan Ahrens, vice president and chief operating officer of AdvisorShares, an ETF provider with $670 million in assets, said officials from Knight called him Thursday morning and addressed his concerns about a few of AdvisorShares’ ETFs that were trading at wider spreads than they would normally. Knight fixed the problems with its ETFs by adding liquidity, he said.

Reporting By Jessica Toonkel; Editing by Jennifer Merritt and Phil Berlowitz

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