11/16/2010 4:00 PM ET|
Are ETFs a market menace?
A controversial new report says that exchange-traded funds distort the stock market and are behind an escalating number of trading failures. Should investors worry?
Could exchange-traded funds blow up and take the markets down with them?
A report released Nov. 8 argues that ETFs are "radically changing the markets," raising the prospect of a "panic-driven market meltdown."
ETFs are funds that hold all the securities in an index and themselves trade like a stock.
The report, produced by researchers at the Kauffman Foundation in Kansas City, Mo., which supports research on entrepreneurship, has its shortcomings -- and was met with howls of derision from ETF experts. "A whopper," said Dave Nadig of IndexUniverse; "riddled with untruths," said Tom Lydon of ETF Trends.
But the report's authors, Harold Bradley and Robert Litan, have considerable expertise of their own. Bradley, the foundation's chief investment officer, was formerly head trader and a senior portfolio manager at the American Century funds. He helped introduce the first stock-index futures contract in 1982 and was a pioneer of electronic trading. Litan, the head of research at the foundation, has worked at the prestigious Brookings Institution and is a widely respected economist.
The proliferation of ETFs, the report contends, raises at least three worries. First, these funds have overly concentrated the ownership of thinly traded stocks. Second, they have led to an escalating number of trading failures. Third, ETFs could trigger another massive market swing like the May 6 "flash crash."
Let's start with concentration. According to the report, a single ETF, the iShares Russell 200 Index Fund (IWM), is among the 10 largest holders of 1,737 stocks -- many of which also are held by other iShares ETFs.
Yet ETFs aren't traditional mutual funds. At an ETF, the manager's job isn't to make judgments on single stocks, but merely to keep the portfolio as close to its index as possible. And, in contrast to a mutual fund, "no one stock represents a large portion of the typical ETF," says Gus Sauter, the chief investment officer at Vanguard Group.
Overconcentration might even have been more worrisome in the pre-ETF era, when big mutual funds routinely stomped in and out of small stocks. "But what if you double the size of ETFs?" Bradley asks. "What if you double them again?" Because ETFs must buy the stocks in the indexes they track, regardless of price, it is legitimate to wonder whether values aren't getting out of whack as ETFs come to dominate the market.
And every investor should worry whether the instant liquidity that ETFs purport to offer should be taken for granted in thinly traded markets.
What about trading failures? The Kauffman report says increasing numbers of buy orders for ETF shares are failing to "settle," or going uncompleted. Fund sponsors don't agree.
"Based on what we've seen, ETFs settle much more efficiently than single stocks when you look at it as a proportion of total volume," says Leland Clemons, a director in the capital-markets group at iShares, the largest ETF sponsor.
At the very least, regulators should look into the Kauffman claim that ETF trades fail at 10 times the rate of individual stocks.
Finally, the Kauffman report says that as ETFs grow, the firms that sponsor them have an increasing obligation to buy the underlying securities. That, says the report, means the ETFs might run out of cash if they had to buy during a "short squeeze," when stock prices can spike upward as traders scramble to cover their short positions by buying more shares. That, the report says, could trigger a systemic panic.
Here is where the report loses me. Investors who want to sell must get their money back in the secondary market, not from the ETFs themselves, so the funds don't need to keep cash on hand. It is market makers, rather than the ETFs, that are obligated to buy or sell securities on behalf of the funds.
"The risk of short selling is not inside the ETF," says Gary Gastineau, who helped develop ETFs at the American Stock Exchange in the early 1990s and now runs ETF Consultants in Summit, N.J. "As an investor in the fund, you're not subject to those risks; you're protected from those risks."
"I'm confident that the structure of ETFs mitigates the risk of the short squeeze that (the Kauffman authors) are concerned about," Clemons says. "It cannot happen."
In the end, I don't think investors need to fear that ETFs pose the "systemic risk" the Kauffman report suggests. But, as Bradley says, "How these things work is opaque at best." When such a veteran investor struggles to understand ETFs, it is a sign that these funds still need to do a better job of explaining exactly how they work.
VIDEO ON MSN MONEY
As a member of an individual investor group whose overall purpose is investing in equities/etc, this somewhat conservative investor group has developed an ETF portfolio that avoids some the riskier offerings. So as long as my group advisors say ETF's are safe, I will be an investor. But you need to do your homework or trust your advisers to do it for you.
Copyright © 2014 Microsoft. All rights reserved.
Fundamental company data and historical chart data provided by Morningstar Inc. Real-time index quotes and delayed quotes supplied by Morningstar Inc. Quotes delayed by up to 15 minutes, except where indicated otherwise. Fund summary, fund performance and dividend data provided by Morningstar Inc. Analyst recommendations provided by Zacks Investment Research. StockScouter data provided by Verus Analytics. IPO data provided by Hoover's Inc. Index membership data provided by Morningstar Inc.
[BRIEFING.COM] Recent action saw a continuation of the range-bound trade that has essentially kept the S&P 500 where it began the trading day.
The technology sector (-0.8%) remains weak, which has prevented the broader market from climbing above its flat line. All things considered, despite today's loss, the technology sector is flat for the week versus a 0.7% gain for the S&P 500.
The tech sector will be in focus again tomorrow as participants will react to a full slate ... More
More Market News
|There’s a problem getting this information right now. Please try again later.|
MUST-SEE ON MSN
- Video: Easy DIY smoked meats at home
A charcuterie master shares his process for cold-smoking meat at home.
- Jetpacks about to go mainstream
- Weird things covered by home insurance
- Bing: 70 percent of adults report 'digital eye strain'