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Why ETFs are Worrisome

You can trip over your shoelaces trying to understand the true mechanics of exchange-traded funds, let alone the worries over ETFs. So let’s make it simple: From a worry perspective, just look at the alarmingly high level of ETF failuresto settle.

CNBC.com

A settlement failure occurs when somebody’s not delivering something they’re supposed to—in this case, the cash or securities that are required within three days after the transaction. With ETFs, some settlements are stretching out 15 to 16 days.

The result could be a “daisy chain” of events that, ultimately, could hurt investors if the market gets rattled.

Using data from the Basis Point Group, which assesses risk using basis points on a scale of one to 100, these numbers through March pretty much say it all:

—Daily individual stock failures are between .40 and .60 basis points.

—Daily ETF failures are 12 to 16 basis points.

—That number surged to 40 basis points on Quadruple Witching Day on March 18, when stock index futures, stock index options, stock options and individual stock futures all expired.

(Read Bob Pisani's take: ETFs and Technicals—Pay Attention!)

“The normal amount of noise in an equity is a half a basis point,” says Fred Sommers of Basis Point.

Flash Crash: One Year Later - A CNBC Special Report
Flash Crash: One Year Later - A CNBC Special Report

“If everybody keeps telling me an ETF is the same as an equity, shouldn’t ETF failures be a half a basis point, too? They’re not.”

Something often overlooked, Sommers adds, is that every ETF is supported by six parties: The sponsor, distributor, custodian, authorized participant, investment manager and transfer agent. “Forget the market,” he says. “Those six guys have to stay totally in sync.”

With so many moving parts, he adds, “my big worry is that somebody drops the ball in here. Because we’re so interconnected—somebody chokes.” As last year’s Flash Crash showed, “It’s all daisy-chained together. If somebody hiccups, there is an enormous daisy chain in place. These people are all relying on cash being delivered. If it’s not, you have a big problem.”

To which the ETF industry says: Nonsense. In a rebuttal to a report from the Kauffman Foundation on settlement failures, Morningstar’s European ETF Strategist Ben Johnson said the fails are, in large part, tied to the sheer velocity of ETFs relative to stocks.

“Given that the velocity of the (SPDR S&P 500 ETF) is more than 10 times that of one of the most heavily traded individual stocks on the planet (Citigroup ), one mathematically would expect to see a greater incidence of settlement failures in shares of SPY and other similarly heavily traded ETFs,” he wrote.

Perhaps, but as Sommers says, “If settlement doesn’t mean settlement, then we have a problem.”

Questions? Comments? Write to HerbOnTheStreet@cnbc.com

Follow Herb on Twitter: @herbgreenberg

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