Posts filed under “ETFs”
ETF’s Firm Foundations by Matt Hougan
November 20, 2010
Matt Hougan is the President of ETF Analytics and the Global Head of Editorial for IndexUniverse. This is a guest column written by him in response to the recent negative press reports about ETFs.
Over the past few months, a series of poorly researched “white papers” have criticized exchange-traded funds and raised questions about the soundness of the ETF structure.
These papers—from the Kauffman Foundation, Bogan Associates, and others—center on three main assertions:
1) ETFs are fundamentally flawed and subject to collapse during stressful market conditions.
2) ETFs are a serious threat to market stability and are likely to cause future “flash crashes.”
3) ETFs are driving up the correlation between individual stocks, ruining price discovery in the markets, and thereby threatening capitalism as we know it.
All three assertions are false. They rest on a foundation of flawed logic, simple misunderstandings of ETF structures, and superficial research.
Despite transparent flaws, these arguments have received widespread media attention, from CNBC to the Financial Times. That’s a shame, because even a little bit of research could debunk the claims quickly.
Claim 1: ETFs Are Fundamentally Flawed and Could Collapse
The argument that ETFs could collapse was first advanced by a research outfit named Bogan Associates in a white paper published on September 15, 2010. It centers on the fact that many ETFs have high short interest, often many multiples of the number of shares outstanding.
The Bogan report focused on the SPDR S&P Retail ETF (NYSEArca: XRT), which at the time the report was written had over 500 percent short interest; in other words, each share in XRT had been sold short five times.
That sounds terrifying. How can an ETF have more shares sold short than exist in the first place? But it happens regularly with both stocks and ETFs, and it is both perfectly legal and safe.
Imagine that I own all of the shares of XRT. I want to earn a little extra money, so I lend them to you, for a fee, so that you can sell them short. You sell them to a guy named Bob. XRT has 100 percent short interest.
If Bob then lends them to someone else who sells short, the ETF now has 200 percent short interest. They may then lend the shares to another party, and so on.
Bogan’s particular concern with ETF short interest ties to one of the most important features of the ETF structure: the ability of large shareholders in the ETF to “redeem” shares back to the ETF issuer. If a large institution owns 50,000 shares of a fund like XRT, it can give them back to the ETF issuer and receive in exchange an equal value in the underlying stocks held in the ETF portfolio.
Bogan’s concern is that if even one-fifth of the people who bought XRT from short sellers redeem their shares, the ETF provider will be forced to hand out all the underlying securities in the fund. The fund will then be left holding nothing, and anyone who still has XRT in their portfolio will be left holding worthless paper.
It’s easy to see the concern. So easy, in fact, that the lawyers who designed ETFs put protections in place to guard against this situation. Those protections vary in detail but follow a similar form: When ETFs have high short interest, redeeming shareholders must prove they have clean, unencumbered ownership before a redemption is processed. This language exists in every prospectus I’ve looked at; the team at Bogan Associates either didn’t open a prospectus or was simply engaged in scare tactics.
The Kauffman report, published last week, took this mistaken concept and shoved it one tangled step further. Kauffman’s primary concern was that, during a market crisis, investors might place huge buy orders for an ETF, flooding it with cash. They suggested that the ETF issuer would then have to chase stocks, trying to put that cash to work. If the issuer couldn’t buy the shares, the ETF’s value would be in question.
Cassandra Does Tokyo is a former hedge fund manager and ex NY Trader, who is now living abroad. ~~~ ETFs clearly can provide some advantages for obtaining otherwise-expensive-to-obtain exposures for thematically-oriented investors. More noteworthy perhaps is the way that such vehicles have captured the imagination of Promoters and Managers as a salvation for otherwise stagnant…Read More
Good article from Bob O’Brien in Barron’s warning about the dangers of 2X Short funds: Beware of Leveraged Short ETFs. Its not just the short leveraged ETFs, its all of the leveraged ETFs that have the same slippage characteristic over time. As anyone who has ever traded them can tell you, they fail to track…Read More
A very interesting article in Barrons about the role ETFs — Extremely Troublesome Funds — played in the May 6th flash crash. It seemed the usual liquid, widely traded funds had a sudden and unexpected vulnerability, as liquidity dropped steeply, and bids faded away. “ETFs represented 70%, or 227, of the 326 securities for which…Read More