In the burgeoning world of exchange traded funds – Barron’s reports that they have almost $1 trillion in assets in the U.S. – there are always new opportunities. But some think there are new risks – in the form of short squeezes and more mini-market meltdowns – or flash crashes.
A flash controversy has been sparked the Ewing Marion Kauffman Foundation, (home to such bloggers as Paul Kedrosky.) A report, “CHOKING THE RECOVERY: Why New Growth Companies Are Not Going Public And Unrecognized Risks Of Future Market Disruptions,” by Harold Bradley and Robert E. Litan, suggests that ETFs may be unmooring price discovery in small caps to the peril of small cap companies and ETF investors alike.
One key to understanding this argument is that the instruments intended to represent the market are fast becoming the market. As traders seek easy exposure to small caps or lesser-researched areas of the market, they are not buying individual names; they’re buying indexes. Increasingly, some say, that leads to a lower dispersion of prices – all stocks are floated on a rising tide, regardless of their fundamentals. Or, as Bradley and Litan argue: “Simply put, we will argue here that ETFs and the derivatives built around them have become the proverbial tail that wags the market.”
That’s what happens when a liquid derivative is constructed on an illiquid base. An ETF trades as a stock, and ETFs themselves represent 25% or more of daily trading volume on the New York Stock Exchange. But ETFs are not, like index funds, claims on a portfolio of individual companies. Rather, they are claims on the performance of an individual index. Here’s where the illiquidity potentially arises. An ETF keeps its tracking error low because Authorized Participants arbitrage the difference between the ETF’s net asset value and its benchmark, by buying the underlying stocks in the index and exchanging them for a “creation” ETF unit, (50,000 shares of an ETF) or conversely by redeeming a creation unit for the underlying stocks.
How easily can they do that? Bradley and Litan argue that, for IWN, an ETF that tracks the Russell 2000, it would take 41 days of trading to cover a 10% drop in the index without having a market impact cost. That’s because most of the stocks are relatively illiquid compared to those included in the S&P 500.
Why this matters is because ETF investors expect their investment to track the benchmark second by second. That didn’t happen on May 6 flash crash.
What’s worse, Bradley and Litman argue, is that the collapse in IWN seemed to have a contagious effect on the more liquid SPDR that tracks the S&P 500. So instability in one sector can quickly migrate – in times of market crisis – to other sectors. It’s worth remembering that 65% of the trades cancelled that day were in ETFs. The arbitrage mechanism broke down as APs withdrew from the market.
The discussion has inflamed controversy because it has been headlined: “Can an ETF Collapse?”
Bradley and Litman are following up on the provocative white paper, given just such a headline, by Bogan Associates. “Take the SPDR S&P Retail ETF (NYSE: XRT) as an example. The number of shares short was nearly 95 million at the end of June, while the shares outstanding of the ETF were just 17 million. The ETF was over 500% net short! Or to look at it from another perspective, the ETF’s operator, State Street Global Advisors, believed that there were 17 million shares of the SPDR S&P Retail ETF in existence and owned shares in the S&P Retail Index portfolio to underlie those 17 million ETF shares. But, in the marketplace there were another 95 million shares of the ETF owned by investors who had purchased them (unknowingly) from short sellers. 78 million of those ETF shares were serial short—that is they had been borrowed and re-sold more than once – or they were naked short (not borrowed at all). The short sellers had promised their prime brokers to create those non-existent shares (above and beyond 100% of the shares outstanding) if necessary to cover their short in the future.”
Bradley and Litan aren’t concerned so much about the possibility of an individual ETF collapse – and ETF specialists say they can’t collapse, so individual investors are safe – as the systemic risk that could arise from a “run” on an ETF.
That’s the short-sale issue. Should there be an abrupt rise in an ETF price – say 5% – the short-sellers might be forced to cover their positions by buying back the ETF on the open market or purchasing the underlying shares for a creation unit. With so much short interest on some ETFs, that may cause market perturbations. First there is a possible disconnect in the arbitrage process as shorts rush to the exits. They are bidding up the ETF faster than they are the underlying, precisely because of the asymmetry in liquidity. Conversely, with so many implicit bids to cover so few offers – relative to normalized volume – there could be a gapping out in price for relatively infrequently traded stocks, making for additional difficulties at the AP level, since they are, in effect, the market. If they’re not going to trade an underlying that has surged in price, penny offers paint the tape, with cascading effects.
Therein, suggest Bradley and Litan, lies another May 6 debacle: does the liquidity asymmetry between an ETF and its underlying portfolio create a potential for disorderly markets.
“We can’t seem to list more U.S. companies, so instead, we create enormously complex packages that enwrap the same finite universe of securities and assets and call it innovation,” they say. “Just because small cap companies that may individually be illiquid are wrapped up in an ETF, which itself becomes liquid, does not make those stocks liquid. Any heavy trading in the ETF will drive the prices of the individual underlying stocks, which will be set in far fewer transactions. Indeed, to the extent that investors view the ETF has a substitute for buying the individual stocks, then ETFs may actually reduce liquidity in the underlying stocks.”
How would that happen?
“Put simply, the marketing strategies that sell ETFs as frictionless and unconstrained investment vehicles do not account for the inherent difficulty of trading the securities within these packages; the liquidity of common stocks does not match the investors’ demands for immediacy and liquidity today.”
That has led to quick responses from ETF specialists, including Scott Burns at Morningstar, who says: “I don’t have a very high impression of this report at all. I mean, it’s kind of a rambling diatribe that accuses ETFs of stunting the economic recovery to being the potential for future market collapses.” There have been other, less-than-glowing reports inside the index universe community.
But others say there may be a point, including Jason Zweig, at The Wall Street Journal. In the end, Zweig reaches a conclusion that complements Bradley and Litan: Markets depend not just on liquidity but transparency – and the more of it the better.