“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.”
That comment by me last week about the guts of an ETF created somewhat of a stir in the blogosphere and in the ETF industry—as did the topic of the piece I had written, which was headlined: “Can an ETF Collapse?”
The piece focused on the SPDR S&P Retail ETF, which has a short position that is five times the size of the shares outstanding. It was based on the concerns and questions raised in a report by Andrew Bogan of Bogan Associates, an investment firm, about the possible dangers inherent in ETFs.
In subsequent discussions with industry execs, analysts and in reading what bloggers have written, the bottom line of their very loud message to me: Don’t worry—the system will work.
And what about the idea that the guts of an ETF are complex? Such a suggestion—say many who trade, sponsor or in one way or the other make a living off ETFs—is to imply ignorance on behalf of the person making the observation. (Shucks!)
Complexity, of course, is in the eyes of the beholder. (Check out “Creation of an ETF” from the Investment Company Institute.)
Never mind that all ETFs aren’t created equally, in their simplest form: ETFs are launched by a sponsor, such as Barclays (I-Shares) or State Street Global Advisors (SPDRs.) These sponsors are ultimately responsible for the safekeeping of the ETFs shares outstanding. The fund’s portfolio is created when so-called “authorized participants” buy a “creation basket” of stocks and deliver them to the ETF in return for a “creation unit.” The reverse occurs when shares are redeemed.
The role of the authorized participant “is to settle trades in the marketplace,” says Jim Ross, who runs the ETF business at State Street, which owns the SPDRs. He adds emphatically, “An ETF can’t fail.” And he stresses that all 74 of his firm’s ETFs hold the underlying assets.
What about if an unusually high number of shares are sold short, as is the case with the SPDR retail fund?
Plenty of bloggers and industry analysts phoned me or penned pieces with their own explanations—some of them worthy of a white board matrix. Their bottom line is that the authorized participants generally put up enough collateral for shares sold short, and that if all else fails, the beauty of an ETF is that more shares can be created.
“On the surface, ETFs are very simple vehicles that allow investors to easily and efficiently build long-term portfolios or make a short-term bet on a wide variety of asset classes, is the way Michael Johnston put it in his explanation on the ETF Database. “But a look under the hood reveals a number of nuances and complex mechanisms that are in place to keep everything running smoothly.”
And in a nearly eight-minute video trying to explain how an ETF can be so heavily shorted while not posing any risk to holders, Bradley Kay, Morninstar’s director of European ETF Research explained that with the collateral of those shorting, there is “very little net economic danger.” He went on to say that “it’s all unseen; it’s in the hidden plumbing of the financial system that this is all occurring.”
Which gets back to the notion of what constitutes "complex" and creates concerns: If there is anything we’ve learned from the recent financial crisis it’s that anything “hiding in the plumbing of the financial system” with “nuances and complex mechanisms” can have a way of coming back to bite investors.
“It would be interesting to ask investors how many of them want their assets held in hidden plumbing instead of by their fund manager,” Bogan says.
Furthermore, Bogan concedes that even the likes of the SPDR retail fund, with its 500 percent net short positions, could be smoothly unwound in a crisis.
“That does not guarantee that it would unwind smoothly,” he says. “The smooth unwinding requires that all the counterparties (myriad hedge funds, authorized participants, etc.) are able to deliver shares or cash when demanded. Under normal circumstances they should be able to do so. But under extreme market conditions, the owners of ETF shares are implicitly relying on the creditworthiness of unknown counterparties. What if one, or some, of those counterparties are not credit worthy or cannot deliver?”
This isn’t something investors in mutual funds or traditional listed stocks have to worry about, Bogan says, and “we believe this is very poorly understood by most retail and professional ETF owners.”
Needless to say, with ETFs as the latest growth business on Wall Street, Bogan and others like him who are concerned about their possible pitfalls are in the minority. For now.