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.
Strangely enough, this liability exists mainly in the world of traditional open-ended mutual funds, where investors can drop huge amounts of cash into the funds at the end of the trading day.
ETFs were actually designed specifically to avoid this mutual fund cash-drag problem. When institutional investors create new shares of an ETF, they must typically deliver to the ETF company the exact securities the ETF wants to hold. The ETF issuer won’t create shares unless the Authorized Participant can deliver the underlying securities, so the ETF itself is always fully invested.
This argument was so transparently wrong that Kauffman issued a correction after the original piece was published.
The authors haven’t given up, however. They are now telling the media that ETFs are subject to short squeezes—that if all the investors who have sold short various small-cap ETFs want to cover their shorts in a single day, the ETF could jump crazily in value. Somehow, the authors think this could leave ETF investors holding the bag.
It’s true, of course, that massive short covering would drive up the price of ETFs. As investors rush to cover, institutional investors would create more shares of the ETF by buying up all the stocks the ETF holds and delivering them to the ETF issuer. That would drive the price of the underlying securities up, and the price of the ETF would rise. That’s not a flaw in markets; that’s just how markets work.
ETFs in that sense are a pass-through mechanism. Lots of people buying small-cap ETFs would drive up the price of small-caps stocks the same way as if lots of people bought the individual stocks directly.
Claim 2: ETFs Are a Serious Threat to Market Stability
Claim No. 2 stems from the fact that ETFs were hit hard by the May 6 flash crash. Sixty-eight percent of the trades canceled following the flash crash were ETF trades.
That is objectively true. ETFs were uniquely exposed to the fallout of the flash crash, and they could be exposed to future flash crashes as well. Because the value of an ETF is based on the value of the securities it holds, mispricing in a single stock can create unusual valuations in hundreds of ETFs.
But to argue that ETFs “caused” the flash crash confuses causation with correlation, and contrasts directly with the data. The SEC went through a vigorous study of the flash crash, concluding that an oversized trade in the futures market set off the chain of chaos, wreaking havoc with computer algorithms and confusing pricing throughout the market. This naturally found its way into ETFs, because of the reasons highlighted above.
The SEC has responded surprisingly well to the flash crash, putting in place circuit breakers that halt trading when unusual pricing occurs. The Kauffman report suggests that these circuit breakers “should immediately apply” to ETFs. I agree, and so does the SEC, which is why those circuit breakers were already in place when Kauffman wrote its report. This is a smart new regulation, one that dramatically reduces the risks of future problems.
The Kauffman report also gets hung up on the idea that ETFs often dominate the list of securities with failed trades, noting that ETFs make up all of the top 10 securities fails from January 1 to September 30 of this year. There are vague accusations that there is something untoward here.
Again, these concerns fall apart on further scrutiny. ETFs dominate the list of failures-to-settle because there is a mismatch in settlement windows between retail trades and market-maker trades. Short sales are supposed to settle three days after they take place (called “T+3” settlement). But market makers have six days to settle trades, called “T+6.” Most of the ETFs “fails” that are reported simply fall into this settlement window mismatch. And the National Securities Clearing Corporation guarantees all trades once they’ve been entered into settlement, so the suggestion that somehow trades in the settlement process are actually failing to ever settle is a fallacy.
Claim 3: ETFs Are Ruining Capital Markets
The third thrust of the anti-ETF argument is that they are ruining capital markets by wrecking the process of price discovery. This is the central theme of the Bogan report.
The idea is that as more investors buy and trade broad-based products like ETFs rather than single stocks, the market for single stocks becomes inefficient.
This one has a kernel of truth. The rise of indexed assets—of which ETFs make up maybe 10 percent in the most concentrated asset classes, and far less if you include notional futures and options exposure—must by definition increase correlations a little within the marketplace. But the idea that they have fundamentally changed the nature of the capital markets is laughable.
Indexed assets still represent a fraction of total assets on the market. There are still plenty of active investors out there looking to uncover undervalued small-cap stocks, or ferret out hidden values in the bond market. If the markets had become radically inefficient, one would expect to see significant private equity activity in the small-cap space. In fact, PE activity is down.
The easiest response to this assertion, however, is a simple examination of the data Kauffman used to support it. In the report, Kauffman points to a chart showing that intraday correlations between single stocks are at the highest level in recent years. The only time correlations have been this high was in 1987 and the 1930s.
Maybe those years have significance. Could it be that single-stock correlations rise during crisis moments?
Anyone who’s been in the market for a while knows that what’s driving the market right now are broad macroeconomic factors like QE2, regulatory uncertainty, tax uncertainty, and European debt loads. Weighed against Ben Bernanke dropping $600 billion from the proverbial helicopter, AMD’s ability to design a slightly better microprocessor than IBM simply doesn’t hold up.
That’s not what’s moving the market today. It’s a risk-on, risk-off world.
Why All the Attacks?
If the basic facts lay so firmly against the arguments advanced by Bogan and the Kauffman Foundation, why do those reports exist? And more importantly, why are they gaining traction in the media?
The answer is simple: ETFs are a disruptive technology.
They are disruptive, as everyone knows, on a few levels. They offer dramatically lower fees than traditional actively managed funds, taking money away from Wall Street managers and putting it into the pockets of investors. They also provide individual investors access to areas of the market previously reserved for the largest institutions.
But the disruptive nature of ETFs is larger than that. From a big-picture perspective, ETFs reject single-stock analysis as the best approach to investing. That rejects the foundation upon which most of investment banking, Wall Street research, and financial media are built. Instead, ETFs line up with decades of academic data showing that it’s persistently difficult for investors to add value choosing stocks. ETFs offer a different vision, one focused on the kind of macroeconomic analysis that truly moves markets: analysis that considers not IBM vs. Cisco, but China vs. the US.
That’s a big change, but it’s a change for the better. This is why ETFs are growing an order of magnitude faster than traditional mutual funds and are coming to take a larger share of daily trading volume on the exchanges. They represent a new, and in many ways better, way of approaching the market. But there will always be people who resist change, even if it’s for the better.
We thank Matt Hougan for providing this viewpoint for our readers. We also note an additional item that counters the Bogan and Kauffman assertions.
The SEC provided this in response to an investor inquiry.
Dear Mr. (name kept anonymous by request),
The attached information responds to your October 1, 2010 e-mail inquiry to the United States Securities and Exchange Commission (“SEC”) with respect to short selling in exchange-traded funds (“ETFs”). As discussed in our telephone conversations over the course of this month, the attached links discuss and respond to the Bogan Associates paper that was posted on the FT.com/alphaville blog on September 18, 2010 (link provided in your e-mail). As also discussed, you may call the SEC’s Division of Trading and Markets at (202) 551-5777 if you have further questions about this matter.
Please note that this response is intended to provide general and informal guidance, and is not intended to be the formal or binding legal advice of the Commission or the staff and is not a substitute for, and may not be relied on instead of, the actual federal securities laws themselves, or advice of legal counsel. This may not be a complete discussion of all the possible issues arising under the federal securities or other laws.
Please also note that the attached materials (hyperlinked herein) represent a sampling of responsive information, and are not necessarily a comprehensive package of information about short selling in ETFs.
• What’s the Hoopla? Can an ETF Really Collapse? Aaron Kehoe, Director, Head of ETF Strategies, Knight Equity Markets, available at NYSE.
• Demystifying the Structure of an ETF, from NYSE Euronext website “Exchanges-Blogging about NYSE Euronext Markets,” available at NYSE. The webpage provides links to four different responses, including the Kehoe article listed above, to the Bogan Associates position.
• Morningstar video report ETF Collapse Concerns Unfounded, available at Morningstar and included related links to the articles Your ETF Will Not Collapse (Sept. 24, 2010) and Your ETF Will Not Collapse: A Technical Addendum (Sept. 24, 2010).
We thank our friend and the investor addressee who asked to remain anonymous, for forwarding this SEC response.
As for ETFs, Cumberland uses them extensively in US and foreign-oriented styles and in our Global Multi Asset Class.
David R. Kotok, Chairman and Chief Investment Officer