Bloomberg News

Meet the Force Behind the Scenes in the $2.4 Trillion ETF Market

February 26, 2014

Bloomberg Markets April 2014

This story appears in the April 2014 issue of Bloomberg Markets.

Reginald Browne tilts his 6-foot-5-inch frame forward to reach a chirping phone.

“What do you want, what do you need?” he asks.

It’s his standard greeting for just about anyone who calls, Bloomberg Markets magazine will report in its April 2014 issue. This time, it’s a representative of a large public pension fund who’s thinking about moving money into exchange-traded funds for the first time. Browne launches into his education mode, patiently answering questions on how closely an ETF will really track its index, how quickly the investor can get in and out and how much it will cost to trade.

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Behind Browne, in a cramped midtown Manhattan office, the traders who work for him offer a marked contrast to his easy calm. In two back-to-back rows, they fire questions and instructions at each other as they watch banks of flickering computer monitors and make decisions in seconds on the prices at which they will buy and sell ETFs.

“What are we offering for EEM?” demands one.

That’s the iShares MSCI Emerging Markets ETF (EEM:US), a $31 billion collection of stocks from more than 20 countries.

Browne, 45, known as Reggie, is a senior managing director and head of ETF trading at New York–based Cantor Fitzgerald LP. There, he presides over one of the most complicated market-making operations on Wall Street. ETFs are among the fastest-growing investment classes in the history of finance -- with $2.4 trillion in assets under management as of the end of December, a number that has doubled in just the past four years.

A Key Force

Browne, who until September was head of ETF trading at Knight Capital Group Inc. (KCG:US) (now KCG Holdings Inc.), has helped create hundreds of funds -- advising providers such as BlackRock Inc.’s iShares, Charles Schwab Corp. and Vanguard Group Inc. He has also been a central figure in helping ETFs grow globally and a key force in selling their merits to investors.

“Reggie’s one of the most influential people in building the ETF landscape over the last decade,” says Rodney Comegys, global head of capital markets at Vanguard, the third-largest provider of ETFs. “He’s a missionary, especially in the institutional space. He’s the person on the edge showing people the power of the exchange-traded fund.”

The son of a U.S. Air Force loadmaster and a banker, Browne downplays the credit ETF providers give him.

“Our job is to help clients deploy their capital efficiently; that’s all,” he says. “The ETFs do the rest.”

Tony Kelly, head of capital markets at iShares, the biggest provider of ETFs worldwide, says Browne is too modest.

Good Listener

“Reggie has been so successful because he does a better job at listening and figuring out what clients need,” he says.

ETFs, which were introduced in the U.S. 21 years ago, offer the diversity of a mutual fund with the tradability of a stock. Each ETF is a bundle of securities, almost always tracking an index, that is listed on an exchange. Tradable throughout the day, transparent and generally less expensive than mutual funds, ETFs have grown from about $79 billion in assets in some 100 funds in 2000 to $2.4 trillion as of Dec. 31 in almost 5,000 funds, according to BlackRock. (BLK:US) Some $700 billion of the assets were outside the U.S. on that date. They’re growing fastest in Asia, where ETFs are a $168 billion market. Europe accounts for $420 billion.

“There’s been no other investment vehicle as transformative as ETFs,” Browne says. “They’ve allowed individual investors to get into so many asset classes. Gold, for example. You had to call a specialized broker, and now you just buy it through your Schwab account.”

$15.3 Trillion

In 2013, U.S.-listed ETFs accounted for $15.3 trillion in equities trading, or 27 percent of the trading on all U.S. exchanges, according to NYSE Euronext. They’ve been hugely disruptive to active stock- and bond-picking mutual funds. From 2008 to the end of 2013, U.S. ETFs gobbled up $895 billion in new money, according to the Washington-based Investment Company Institute -- money that might otherwise have gone to actively managed mutual funds. Those mutual funds garnered just $403 billion in the same period. While traditional mutual funds still manage a much larger $10.6 trillion, ETFs are gaining fast.

“ETFs are the biggest innovation in the distribution of investment products since the invention of the mutual fund in the 1920s,” says Rick Ferri, founder of Portfolio Solutions LLC, a Troy, Michigan–based financial adviser with $1.3 billion in client assets.

Hedge-fund managers were among the first to embrace ETFs. Retail investors have piled in over the past decade, and conservative institutions like pension funds and endowments have taken them up with increasing gusto in the past three years.

Integral to Growth

“Reggie and his team have been an integral part of the growth of the ETF business,” says Shawn Matthews, chief executive officer of Cantor’s brokerage unit. “A team of that reputation and knowledge is very difficult to find and would be very difficult to replicate.”

The love for ETFs is not universal. ETFs may accelerate and magnify market swings by moving huge blocks of stock in an instant. After an accidental sell order in futures contracts on May 6, 2010, caused U.S. stocks to lose $862 billion in value in 20 minutes, an investigation by the U.S. Securities and Exchange Commission and Commodity Futures Trading Commission found that 70 percent of all erroneous trades were in ETFs.

Some ETF providers offer funds designed specifically to give sophisticated institutions a simpler way to make complex bets, sometimes using leverage and derivatives. Once these funds are listed, anyone with an online brokerage account can buy them.

‘Too Much Risk’

Browne says the May 6 incident had more to do with the sudden withdrawal of market makers across all equities-trading platforms, and with high-frequency trading via powerful computers, than it did with the ETFs themselves. And he says he doesn’t get involved in bringing to market leveraged ETFs, which can amplify the daily movements of a market two or more times.

“Too much risk. I just don’t do it,” he says.

Browne’s career in ETFs started in 1997, when he joined a group at the American Stock Exchange making markets for the SPDR S&P 500 ETF Trust (SPY:US), known as the Spider. Introduced by State Street Corp. in 1993, it was the first U.S. ETF. Today, his Cantor team of 26 buys and sells shares in hundreds of funds that hold tens of thousands of securities linked to companies, currencies and commodities around the world. It’s a delicate, sometimes risky task performed under pressure.

Providing Liquidity

“If you misprice an ETF” -- that is, offer to buy or sell at the wrong price -- says Darren Taube, one of Browne’s two partners in running the ETF desk, “another firm will come and empty your coffers.”

The market maker’s job is to provide the lifeblood of a healthy exchange: liquidity. That means ensuring there’s a buyer for every seller and a seller for every buyer, and at prices as close as possible to what buyers bid and sellers ask.

While that’s much the same for any traded security, in ETFs it’s more complicated because each fund can be composed of many individual securities and because ETFs cover so many different underlying asset classes. Browne’s traders have to take all this into account when they take orders from their customers, then quote prices at which they will buy or sell.

“They have to do this across stocks, bonds, emerging markets, commodities and everything else ETFs hold,” says David Nadig, director of research at San Francisco–based ETF.com. “What they’re doing is managing a moon shot every single day. It’s crazy complex, and it has to work.”

Midwife’s Role

ETF market makers also perform a midwife’s role in backing new funds as they hit the exchange and an educational role for institutional investors who haven’t yet taken the plunge into ETFs. Browne has long acted as both a gatekeeper for new funds and an ambassador for the industry. He’s traveled the world, from Chile to Hong Kong to the U.K., promoting the product to investment funds and stock exchanges -- and picking up business along the way.

Kelly of iShares recalls how Browne, while still at Knight, won a big slice of ETF trades coming from investors in Latin America. Other market-making firms didn’t listen when Kelly told them investment funds in the region were worried they would run afoul of regulations setting firm deadlines for the settlement of trades. Browne won their business by assuring them trades he handled would be settled on time, Kelly says.

Browne is first among equals in the trio that runs Cantor’s ETF team. His partners, also Cantor senior managing directors, are Eric Lichtenstein and Taube.

Constant Push

Browne works with fund providers on new products and recruits trading clients -- the investors who need convincing that ETFs are right for them. He also meets with regulators and exchanges in a constant push to make more ETFs available to more investors around the world.

“The role I play in bringing out new ETFs, that brings competition and innovation to financial markets,” he says.

Taube conducts the orchestra that is the trading desk, dealing with funds and clients -- ranging from retail brokerage houses to hedge funds -- on day-to-day, or minute-to-minute, issues. Lichtenstein manages risk, making sure the desk’s own inventory of ETF shares and underlying securities are hedged and that the unit stays within Cantor’s limits on committing capital.

Cantor Fitzgerald makes money on its ETF desk by charging clients a spread, or margin, that amounts to fractions of cents per share as they execute millions of trades. Browne, Taube and Lichtenstein’s pay is linked to the profitability of the operation, Browne says. Cantor declined to disclose their compensation.

An Instant Power

When Cantor Fitzgerald lured Browne and his crew to the firm, brokerage head Matthews called them “unquestionably the most knowledgeable and experienced professionals when it comes to the pricing and trading of ETFs.” The hires made Cantor’s small ETF trading desk an instant power. The move was part of a wider expansion by the firm, which lost 658 employees in the Sept. 11, 2001, terrorist attack on the World Trade Center. In the past year, Cantor has started up a municipal-bond sales team, hired seven corporate-debt brokers from Gleacher & Co. (GLCH:US) and bought many of the assets of London-based Seymour Pierce Holdings Ltd., one of the U.K.’s oldest brokerages. Matthews said in October he planned to hire 200 to 300 people this year to boost fixed-income sales and trading in emerging markets.

Basel III

All of this is part of a big shift on Wall Street triggered by the implementation of the U.S. Dodd-Frank law and Basel III, the new global set of capital requirements agreed on by the Basel Committee on Banking Supervision in the wake of the financial crisis. Dodd-Frank curbs what is perceived to be risky activity such as proprietary trading by big banks, while Basel III requires increased capital reserves to guard against future financial tremors.

Browne says that’s why, when he contemplated leaving Knight, he chose Cantor rather than a big bank. The firm is not a bank holding company and is not considered systemically important.

“If you look at regulatory pressures coming, I believe there are head winds for the largest banks and much less for middle-market broker-dealers,” Browne says. “The multinational banks may have more difficulty deploying their capital for different businesses, and that could include ETFs.

Browne, Taube and Lichtenstein met and became friends in 1997, when they worked together making markets for the Spider at the Amex. The action was in old-fashioned pit trading, where personal relationships between traders helped drive the deal flow. That experience, Taube says, still helps, even in a world where trades are all electronic.

Floor Ecosystem

‘‘We’ve taken on the specialists with the most knowledge and experience and built around that,’’ he says. ‘‘It’s the ecosystem that existed on the floor.’’

Taube, 38, and Lichtenstein, 39, left the Amex in 2000 and formed their own electronic-trading shop. Without a big balance sheet to back them, it ran aground, and in 2006, the pair were hired as managers of ETF trading at Newedge USA LLC, a New York–based joint venture of French banks Societe Generale SA and Credit Agricole SA. Browne by that time was working at market maker LaBranche & Co. When he showed up at a fundraiser for brain cancer research organized by Lichtenstein, who had lost a brother to the disease, Taube and Lichtenstein persuaded him to join them at Newedge.

The Vision

‘‘Darren and I are good at trading, but Reggie had the vision for where the industry was going,’’ Lichtenstein says.

In 2009, the trio says Newedge wouldn’t approve their proposal to open a London office. (Newedge declined to comment.) The three jumped with their entire staff of 10 to Knight Capital. They built that firm into one of the world’s largest ETF traders. At its peak under Browne, Knight handled about 12 percent of all published ETF share volume in the U.S., more than any other firm, trading about 178 million shares daily, according to data from Knight.

As Browne and his team rapidly expanded ETF trading volume at Knight, suitors came calling, including Howard Lutnick, CEO of privately held Cantor Fitzgerald. According to Browne, Lutnick spent 3.5 hours in a Manhattan bar one evening in 2011 trying to pry the trio out of Knight. It didn’t work.

Then came Aug. 1, 2012, when a software glitch spit out erroneous trades that cost Knight more than $450 million, nearly killing it. Knight agreed that December to a takeover by Chicago-based Getco LLC, and the combined companies emerged as KCG in July 2013.

A New Home

With the former Knight’s standing among clients damaged, Browne and his partners began looking for a new home. They needed a firm ready to commit a big portion of its balance sheet to ETFs, and the resources to invest in supporting technology.

Browne says he also wanted the same freedom to run his shop that he had at Knight. Lutnick, he says, had a reputation for allowing new teams to prove themselves. (Lutnick declined to comment for this story.)

At Knight, Browne’s team served as lead market maker for 38 percent of all ETFs on the New York Stock Exchange. Every ETF is required to have a lead market maker, or LMM -- a firm that is under contract to the exchange to provide pricing at all times and typically commits capital to establish a new fund’s initial liquidity. In the latter role, Browne made Knight the go-to firm for small and midsize providers hoping to introduce the next big thing in ETFs.

The Godfather

‘‘After the investor, the LMM is probably the most critical piece for a new ETF,” says Adam Patti, founder and CEO of IndexIQ Inc., a New York–based sponsor of ETFs that focus on alternative investment strategies. “That’s why Reggie’s the godfather.”

Browne is getting back into the lead-market-maker business this year, as ETF providers move their business from KCG and other firms to Cantor.

Browne’s ardor for finance began at home in Philadelphia. While his father was in uniform for the Air Force, his mother worked in merchant banking at Mellon Bank Corp. It was his grandmother, a fan of the late television investment guru Louis Rukeyser, who inspired Reggie’s love of the markets. She bought him a gift subscription to Money magazine when he was 12, prompting his first attempt to place a trade. He had a broker on the phone from penny-stock specialist Blinder Robinson & Co. before his mother intervened.

“I had pennies, so I wanted penny stocks,” he laughs.

When he was a 15-year-old Eagle Scout in 1984, he was among a group of local teens chosen by the Union League of Philadelphia for its annual Good Citizenship Awards.

Summer Job

As part of the program, he was paired with a local business leader. He told the league his interests lay in finance, so he was introduced to Randy Gilmore, then a senior executive at the Philadelphia Stock Exchange. Browne parlayed that into a summer job at the exchange, which turned into a full-time job after high school. He attended Philadelphia’s La Salle University part time, earning a bachelor’s degree in finance in six years.

“That’s not because I couldn’t pay for college but because I wanted to work full time,” he says. Browne was a football lineman in high school but left sports behind when he entered La Salle.

Browne is one of the most influential African-Americans in the U.S. financial markets, a distinction that he shrugs off.

“I wouldn’t call attention to it,” he says. “If you’re the first at something, that’s different.”

Joe Searles

Though he served as the Amex’s first black floor official in the 1990s, charged with helping to enforce exchange rules, he says that wasn’t a big deal compared with the election of the first African-American as a member of the New York Stock Exchange. Joseph L. Searles III broke that barrier in 1970.

Browne mentors minority students interested in working on Wall Street and is a member of the National Association of Securities Professionals, a group that “assists people of color and women achieve inclusion in the financial services industry,” according to its website.

It was in the mid-1990s that Browne was drawn to what he remembers as “this cool thing called the Spider.”

Back then, ETFs were strictly a niche product. Today, investment advisers are offering portfolios consisting entirely of ETFs. Fund research firm Morningstar Inc. tracks 150 such firms that in September managed $86 billion, up 37 percent in one year.

ETF Converts

Among institutions, more insurance companies and pension funds are converting their individual stock and bond holdings to ETFs. BlackRock in April created three new ETFs designed specifically to meet the needs of the Arizona State Retirement System, which put $100 million into each the day they opened.

Browne’s trading desk facilitates the buying and selling of ETFs in two distinct ways. For most investors, it means executing their orders on the stock exchange. Computers do almost all the work, with various market makers competing to match buyers and sellers. They take a slim margin on each transaction.

For big institutional investors, whose orders might move the share price, the market maker plays a more active role. Instead of purchasing ETF shares on the exchange for the client, it buys up a representative slice of the fund’s underlying stocks or bonds -- if it doesn’t already hold them -- and presents them to the ETF. The fund hands over newly created shares priced at its net asset value. Selling large blocks of shares works the same way, in reverse.

Quoting Prices

The challenge for Browne’s team lies in the obligation to quote a price to its client when the order is taken. Say a hedge fund wants to put $20 million into junk bonds through State Street’s SPDR Barclays High Yield Bond ETF (JNK:US), which holds about 700 underlying bonds. If Cantor doesn’t own those bonds, its traders have to estimate how much it will cost to buy them, which can take a day. If they hold the securities in inventory, prices may already have diverged from what they paid, and they may have spent money to hedge those positions. The trader taking the call must set a price that covers costs, protects against price shifts before the transaction settles and allows for an acceptable level of profit. He or she has about 45 seconds to do so.

Set the spread too thin and the firm loses money. Set it too wide and the client, who can also monitor the prices of all the securities involved, will look for a better deal elsewhere. Among Browne’s competitors: Goldman Sachs Group Inc. (GS:US) and KCG, which is rebuilding after Browne’s exit.

Systemic Worries

When it comes to backing new ETFs, most of Browne’s calculations revolve around the risk its sponsorship could pose to his own firm. Systemic worries -- for instance, whether an asset class is big enough and has enough underlying liquidity to support an ETF -- he leaves to the SEC, which must approve all new ETF listings.

“Regulators make the decision on whether an ETF poses too much risk to a certain asset class,” Browne says. “I’d argue that we bring more people to a market, more transparency, and that can bring equilibrium to pricing.”

The risks he takes backing new funds don’t always work out. One product he got behind in 2013 was the Barron’s 400 ETF (BFOR:US), which tracks an index that picks stocks that are filtered through a formula based on growth, profitability and cash flow. It’s a strategy even Browne wasn’t sure would gather much interest. The fund now holds about $207 million and was up 15 percent through Feb. 10 since its opening June 4.

Then there’s the Nashville Area ETF (NASH:US), a fund he backed that is composed of companies based in or near Music City and that started Aug. 1. Browne saw the fund as the first of a series of ETFs designed to tap interest in regional U.S. investment strategies. Yet as of mid-February, it was languishing with $6.5 million in assets, and it had a 0.8 percent return as of Feb. 10.

Says Browne: “Having scraped knees can be an education.”

To contact the reporter on this story: Christopher Condon in Boston at ccondon4@bloomberg.net

To contact the editors responsible for this story: Michael Serrill at mserrill@bloomberg.net; Christian Baumgaertel at cbaumgaertel@bloomberg.net


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Companies Mentioned

  • EEM
    (iShares MSCI Emerging Markets ETF)
    • $44.75 USD
    • -0.12
    • -0.27%
  • KCG
    (KCG Holdings Inc)
    • $11.98 USD
    • 0.16
    • 1.34%
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