Have you ever read something that just didn’t seem correct? Recently, an article published in the Financial Times by Andrew Bogan, Ph.D, Brendan Connor and Elizabeth Bogan, Ph.D stated that Exchange Traded Funds could potentially collapse. Their thesis purports that if a situation developed where more investors are shorting an ETF than actually own the shares, there wouldn’t be enough shares left for the long investors if investors redeemed all the shares at once. They claim this would then shut down the ETF entirely and leave someone holding the bag. The article also blamed ETFs for the recent “flash crash,” which saw the Dow drop over 1000 points in a matter of a few minutes. They also argued that ETFs are misunderstood by investors. You can read the article here .
While the article has some interesting points, the ETF industry has quickly proven the thesis absolutely false. How?
Kyle Waller, research analyst at Wiser Wealth Management, Inc, states that “only properly settled shares, in good delivery, can be delivered to the Issuer for redemption.” This basically means that if you purchase an ETF and the trade has settled, then you own the underlying shares. A person simply shorting an ETF does not own settled shares. Therefore, they are taking on the additional risk.
Matt Hougan of IndexUniverse.com stated in his blog, “the [researchers] concern is addressed in the prospectus and Statement of Additional Information (SAI) of every ETF I’ve ever looked at. Here’s what it says in XRT’s [Retail ETF questioned in the article] SAI:”
“An Authorized Participant submitting a redemption request is deemed to represent to the Trust that it (or its client) (i) owns outright or has full legal authority and legal beneficial right to tender for redemption the requisite number of Shares to be redeemed and can receive the entire proceeds of the redemption, and (ii) the Shares to be redeemed have not been loaned or pledged to another party nor are they the subject of a repurchase agreement, securities lending agreement or such other arrangement which would preclude the delivery of such Shares to the Trust. The Trust reserves the right to verify these representations at its discretion, but will typically require verification with respect to a redemption request from a Fund in connection with higher levels of redemption activity and/or short interest in the Fund. If the Authorized Participant, upon receipt of a verification request, does not provide sufficient verification of its representations as determined by the Trust, the redemption request will not be considered to have been received in proper form and may be rejected by the Trust.”
Hougan goes on to say, “This means, when redeeming shares of XRT, you have to say that the shares aren’t lent out. If there’s high short interest in the fund, you’ll have to prove it, or the redemption doesn’t go through.”
Looking at the ETFs that we use here at Wiser, I agree with the assessments of Matt and Kyle. I do not see the Bogan & Connor report as having much merit for concern, especially with the ETFs that we use in our models.
What does concern me is how quickly this report showed up on CNBC without the completion of any fact checks. The report itself lacked the data to prove its points and also contained a few assumptions that are not correct. The report incorrectly assumes that investors poorly understand ETFs because they represent 70% of the canceled trades on May 6th, now known as the “flash crash.” A recent article in Barrons points the finger at Waddell and Reed, a mutual fund company, for starting the flash crash. This triggered other program trading, which resulted in a very volatile day in the market.
Not only did CNBC not do some fact checking prior to talking about the Bogan & Connor report, they also did not really portray ETFs correctly. Kyle Waller picked up on this and commented that, “CNBC called ETFs derivative products, which implies a lot of risk to the average investor. However, the plain vanilla stock ETF truly represents an un-leveraged position in a basket of stocks, deriving its value from the underlying creation unit. These kind of ETFs are derivatives the same way common stocks are derivatives of the company’s value.”
It seems to me that more people need to attend the next ETF conference. So many advisors, individuals, institutions, media outlets and, evidently, Ph.Ds do not understand this innovative product.
You can read the Bogan & Connor Report, CNBC’s coverage, Matt Hougan’s blog, and the iShares Response here:
Index Universe Response to Bogan & Conner Report
iShares Response to the Bogan & Conner Report
iShares Response to Bogan & Conner Followup
iShares Blog on ETFs, Kauffman Report and the Flash Crash
“CNBC called ETFs derivative products, which implies a lot of risk to the average investor. However, the plain vanilla stock ETF truly represents an un-leveraged position in a basket of stocks, deriving its value from the underlying creation unit.”
If the company that sponsors this “unleveraged” position in stocks (e.g. Bear Stearns, Lehman Brothers, MF Global), then what exactly does a client own, and how do they receive it?
Your argument that ETFs aren’t derivative positions is materially false. Clients (except for Authorized Participants) have absolutely no right to underlying holdings. Your statement that ETFs derive their value from underlying assets (which they don’t have) is also false. ETFs trade freely of their “underlying assets” and are worth only what another investor is willing to pay – much like an options contract. Even if an ETF holds a basket of underlying assets, as you argue (this is extremely unlikely, by the way, as most undoubtedly use futures and other instruments to mimic and index), the average client has no right to underlying assets – whether they exist or not.
Doc2 has touched on an issue being discussed within the ETF industry. As more ETFs roll out (300 + expected this year) uneducated investors tend to group them all together as the same. In fact this is far from reality. We believe that ETFs should be called ETP’s (Exchange Traded Products) as a whole. This has already being done within the industry. Then subcategories could be added so that ETFs that hold real assets are called ETFs. Maybe they could call current ETFs that use leverage ETL’s? ETFs that currently trade only futures something else… and so on. This would make it much easier to distinguish the difference from the surface. Today’s reality is that you must understand structure to fully know what your invested in. Here at our firm we believe this understanding falls well within our fiduciary standard to our clients. Large brokerage houses generally have someone with ETF knowledge creating a list for their salesmen (advisor) to use with their clients.
Doc2 has made some very common yet incorrect mistakes in his comment above. ETFs under the 1940 act are in no way shape or form derivatives. This is where CNBC got it wrong also, thus the purpose of this blog post. Under the 1940 Act, if you buy an ETF you own the underlying holdings. If you own 50K shares of the ETF then you have the option of exchanging the shares for the underlying holdings. If you do not have 50K shares, you own part of the 50K share bloc. This block is not owned by the market maker as Doc states, but is held in trust separate from the fund company and the market maker. Clients do have a right to this partial share in cash form, just not to receive the actual stocks. Why would you anyway? Imagine the trading cost to sell 500 companies on the S&P 500 with just a 10k investment! Just sell the ETF in one transaction.
ETFs do get their value from the underlying holdings. This value can be tracked by adding a few symbols to an ETF. For example IVV, the S&P 500; If you want to know the net asset value, go to yahoo finance and enter the ticker ^ivv-iv. This will give you a 15 second quote of all the underlying holdings. It is true that ETFs can and will trade away from these values, but there are market makers in the market looking for arbitrage opportunities which push the prices back to NAV. If an ETF is trading far away from NAV there are several ways to still get the ETF at or very close to NAV. Experience and a good ETF education can save clients a significant amount in trading costs (errors) IF done properly.
ETFs created within the 1933 Act will many times not own the underlying instruments. Most individual investors should not and will not own these types of ETFs. iShares and Vanguard, two of the largest providers of ETFs only have a small number of 1933 Act ETFs.
There are a lot more facts to cover but this is the basics. Keep Cost Low, Maintain a Diversified Portfolio, Invest for the Long Term