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Greenberg: Can an ETF Collapse?

The question of whether an ETF can collapse is the focus of a fascinating new report by Bogan Associates, an under-the-radar investment firm in Boston.

The concern of the Bogan report, as well as other market participants I’ve been talking to, is that the complexity of exchange-traded funds and their increased use as trading vehicles by hedge funds can be quietly but quickly creating serious market risk.

At the heart of the matter is what stock ETFs really are: Derivatives with unlimited share creation prospects. Unlike regular mutual funds, which buy and sell stocks with the cash from investors, ETFs buy so-called “creation units” from participating institutions. Each creation unit represents 50,000 shares owned by an “authorized participant.”

I can’t stress the complexity of the structure. If the very nature of these “creation units” is beyond the comprehension of most investors the actual mechanics of ETFs involve an even far more complex matrix of transactions.

Harold Bradley, chief investment officer of the Kauffman Foundation, goes so far as to say: “These are like unregulated futures contracts because of their unmitigated open interest.”

The “unmitigated open interest” he’s referring to a startling figure in the Bogan report: That while the SPDR S&P Retail ETF has about 17 million shares outstanding, it has around 97 million shares short. That’s right, more than 500 percent of the ETF is net short.

“This implies total gross ownership of XRT in the market of roughly 96 million shares,” says Andrew Bogan, who co-runs the firm with his father, Thomas, a former interim research director at State Street. “So the assets held by the ETF operator (State Street Research - no relation to State Street Global Partners) in this fund are about $680 million, while the implied ownership of all the long holders would be worth $3.9 billion.

“In this extreme example, the ETF operator holds only about 17 percent of the shares that people most likely believe they are buying when they buy XRT in their account. The remaining stock is implicitly promised by short-sellers though their prime brokers if authorized participants”—the institutions that own the shares behind the creation units—wanted to redeem more than 17 percent of the shares owned.”

In effect, he says, this amounts to a “fractional reserve stock ownership system” and a “shadow market caused by massive scale short-selling.”

The big question: Who will be left holding the bag? Retail investors? Prime brokers? Even Bogan and his co-authors can’t answer that; the data is that unavailable and the issue is that complex.

To repeat what I said in CNBC’s Man vs. Machine segment : Many critics are concerned that ETFs have grown well beyond their original intention and have become a monster that will wreak havoc.

The Bogan report certainly speaks to that. State Street Gobal Advisors, which runs the XRT, has not yet responded to our request for comment.