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Greenberg: Are ETFs Another Form of Financial Engineering?

The Kauffman Foundation’s new 60-plus page report on ETFs (exchange-traded funds), which I mentioned here yesterday, has started to cause industry chatter.

One industry exec told me he believed the report is “full of holes.” And Dave Nadig of IndexUniverse wrote, “The levels of “Wrong!” in here are deep and profound. It reflects a serious misunderstanding of how ETFs work.”

But the authors, Harold Bradley and Robert Litan, are standing by what they wrote, including their claims that:

  • The proliferation of ETFs, not high frequency trading, could cause another flash crash.
  • ETFs hurt the creation of IPOs (intial public offerings).
  • And the industry needs significantly more regulatory oversight.

The report's authors go so far as to say they "are worried that the increasing packaging of securities is looking a lot like the financial engineering that created the mortgage mess."

But it's ETFs with unusually high short interest that concerns the authors most, especially the question of how long it would take shorts to realistically close out their positions by buying shares. In a normal short situation, the borrowed shares are purchased; the more shares sold short, the greater the likelihood of a short squeeze, which can artificially push a stock’s price higher.

With an ETF, the mechanics are somewhat more complex, especially given the concentration of ETF ownership in individual stocks. Using the I-Shares IWM Russell 2000 ETF as an example, the report says that on a typical day the ETF comprises more than 37 percent of the entire trading value its underlying securities.

From the report:

“…because the underlying securities are in short supply, mounting obligations of ETF sponsors to purchase them exposes the sponsors to the risk that the cash they have on hand will be insufficient, at the sharply higher prices of the underlying securities, to cover those purchases and thus track the index.

“It is for this reason that short squeezes expose ETF sponsors to failure. In turn, the failure of one or more heavily shorted ETFs could easily trigger a run on other similarly situated ETFs, causing a panic-driven market meltdown (after a brief run up in prices of the underlying securities subject to the short squeeze).

"We believe the danger of this potential chain of events is not well recognized.”

The industry insists this isn't a problem, and that in the end the ETFs can simply create more shares. Problem solved.

My take: In theory, at least.

Disclosure:The nonexecutive chairman of the Kauffman Foundation is chief executive of a mutual fund servicing company. The authors say they had no discussions with the chiarman, who is not involoved in the Foundation's day-to-day operations, about the report.

Questions? Comments? Write to HerbOnTheStreet@cnbc.com

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