A prolonged sell-off would be dangerous for ETFs

Investors polled by researcher Birinyi Associates had expected the S&P 500 to rise 8 percent in 2015, which would've been an average return. Instead, we had the first correction in equities since the financial crisis amid wild volatility and the S&P 500 finished down less than 1 percent.

If this were a game of Monopoly, we essentially finished back where we started, at "Go."

We followed that with a hair-raising start to 2016, where the S&P finished down 1.5 percent after being down more than 2 percent intraday.

Volatility is, in part, due to the explosive popularity of derivatives like options and futures – and Exchanged Traded Funds (ETFs). Buying or selling rights to assets (that's what derivatives are) like stocks gives markets directional signals that overstate actual supply and demand, producing big market swings.

ETFs are, in effect, the most popular derivative. Last year, 81 percent of financial advisors recommended ETFs, according to the Journal of Financial Planning. And, while the rate of conventional institutional turnover (the amount of assets under management sold each year) was 42 percent, according to the Investment Company Institute, the rate of change in holdings for ETFs is an astonishing 2,200 percent, according to ETF portal ETFdb.com.

Dollar volume from just the top 100 U.S.-traded ETFs in 2015 (of 1,100 equity-focused ETFs) was a staggering $16.2 trillion. Combining dollar-flows at public stock exchanges with trading in market centers regulated as brokers (sometimes called dark pools), nearly $70 trillion changed hands in 2015. So, 23 percent of all the money came from trading in 100 ETFs – let's call them the top 1 percent of those roughly 8,000 securities.

ETFs, save for smatterings of active ones with tiny assets, are quantitative. They don't track fundamentals but instead allocate assets via model. If this is what the money is doing, Wall Street is wrong to keep trying to explain market direction in fundamental terms.

When you buy ETF shares, you don't own anything but a trading proxy for assets held by ETF sponsors. ETFs do not increase the number of shares of public companies that can be bought or sold. Public companies bought back about $800 billion of their own shares last year even as money rushed into ETFs. There are only 3,800 companies in the Wilshire 5000 Index — less than half the number it contained at the peak in 1998. The loud institutional complaint about stocks is lack of liquidity — absence of shares to buy or sell.

How is it that ETFs magically have great liquidity? They substitute, optimize and sample the indexes they track. ETF sponsors issue what is, in effect, a collateralized obligation, like a mortgage-backed security, predicated on an underlying basket of stocks. Or cash. Or derivatives.

Leveraged and inverse ETFs that try to outperform or hedge market-moves rely on derivatives. On Dec. 11, 2015, the Securities and Exchange Commission proposed to limit the amount of notional exposure leveraged ETFs would be permitted to use. Regulators have the same concerns we do, clearly.

We should all understand the general risk in ETFs. If the number of investable shares is not expanding and yet money continues to flow through 401(k) accounts to indexes, active mutual funds and ETFs, there is a high probability that all have a claim on the same underlying asset. Only ETFs are substituting a tradable security. In the mortgage crisis, most homes lost value whether the owners were paying their mortgages or not because residential real estate had been artificially extended through derivatives.

The risk in ETFs will only be apparent if and when the stock market experiences a sustained decline. Why? Because there will be more sellers than underlying assets (shares of stock).

The sell-off in August-September of last year didn't equal a prolonged decline. We actually haven't had one since 2008. The recipe for a sustained decline is nearer all the time to complete — especially if we see light jobs numbers on Friday.

Suppose demand for futures and options falls with January expirations (that's what happened last August) and then the Fed raises rates again on Jan. 27?

Let the ETF buyer — and seller — beware.

Commentary by Tim Quast, the founder and president of market structure analytics firm Modern Networks IR LLC inDenver. Follow him on Twitter @_TimQuast.

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