ETF Structure and Its DiscontentsBy Geoff Robinson | Dec 10, 2014
“60% of the SPDR is owned by institutional investors that are trading very rapidly . . . every single day the SPDR is the most actively traded stock in the entire world . . . Why are people doing that? They are trying to hedge; they are trying to be short the market; they are trying to take an equity position while they find a real grown up manager . . . It doesn’t work and it doesn’t work for individuals . . . Say last Friday it traded $23 Billion on a $180 Billion fund. That’s 25% daily turnover . . . It’s a trading vehicle . . . Individuals are going to cut their own throat on it.”
-Jack Bogle, September 22, 2014 – Bloomberg Markets Most Influential Summit
The S&P 500 SPDR—the first U.S. Exchange Traded-Fund (ETF) brought to market—became available to the investment community in 1993. During the 1990’s, the burgeoning ETF industry generally facilitated the purchase and sale of baskets of long-only securities. The revolution was beginning. The investor could now buy and sell index-like products through an exchange rather than through the forefather of the ETF, the mutual fund.
Regulatory Structure. An ETF is typically a mutual fund (i.e. registered under the Investment Company Act of 1940) that applies for exemptive application to trade on an exchange. Certain funds, like those for exposure to commodities or currencies, are not required to register under the 1940 act and instead register under the 1934 Securities Exchange act. In addition, securities listed for sale on exchange must be registered under the 1933 Securities Act. Why point to the regulatory structure? ETFs are currently approved through exemption based on regulation written in the decade following the Great Depression. Fast forward to the 90’s.
ETFs or Exchange-Traded Products (Funds, Notes, and now Mutual Funds, among others) are abundant. One can buy or sell products containing equities, bonds, volatility, currencies, commodities, real estate, hedging portfolios, private equity, or a product that may aim to diversify among a few or all of the above assets. The complexity of these instruments is astounding. While we have discussed deficiencies in ETFs that give inverse and levered exposure as well as ETFs that purport to expose one to alternative investments, we turn to the plain vanilla flavors: long and unlevered ETFs.
Liquidity. The SPDR is typically the most actively traded ETF. The underlying instruments of the SPDR are large capitalization U.S. equities. We do not suspect that the daily volume traded in the SDPR to ever be larger than the liquidity afforded by the underlying securities. However, we cannot give the same assurance with popular funds that give exposure to instruments like high yield bonds and small cap equities. In the high yield bond space, a wave of defaults could heavily effect the underlying fund liquidity. Small capitalization equities generally have much less liquidity than their large cap peers.
Lack of liquidity in the long-only products can be compounded by the mere existence of levered products. While one may dismiss a long Russell 2000 ETF (small-mid cap fund) as one that may lack liquidity, when one stacks the trading activity against the 2x and 3x levered products on both the long and short side, trading activity against the underlying assets garners more scrutiny. We question what happens when the liquidity of an ETF is larger than the underlying instruments. Does the fund collapse? Are the instrument hostage to the trading activity of the fund? As ETF ownership proliferates in the small capitalization space, one may witness stock movements more correlated to the index or sector than previously found. This could distort price discovery and fundamentals of the underlying stocks.
Authorized Participants, T+3 (+1 or +2 or +3) Settlement, and Failure-to-Deliver. Authorized Participants (APs) are market makers for ETFs. They create or redeem large baskets of shares, which are then distributed through the secondary market. Some journalist sounded an alarm related to large settlement times in 2011 and 2013. In the summer of 2013, there was a large amount of ETF volatility and discrepancy between the daily objectives of a fund and its NAV. Whether this was due to APs, underlying investments, or retail/institutional trading on the secondary market, we believe one would likely need to be an insider to tell. Let us examine the T+6 settlement and the possibility of Failure-to-Deliver.
APs typically create shares by assembling the underlying securities for sale to the fund. The shares are delivered In kind to the fund, and the AP receives shares of the fund in increments that typically range between 25K-100K shares/basket. The redemption process is the creation process in reverse. Fund shares are purchased in the secondary market, delivered by the AP to the fund, and the AP delivers the underlying securities in kind.
The process of creating a basket of securities, therefore, requires the AP to acquire underlying securities, which unless owned can take up to T+3 to settle. The actual creation of a basket of fund shares can take an additional time. Creation of a basket likely takes at least T+4 before settlement. We believe that the extra settlement time allows the AP an information advantage over the retail investor: basket creation could be delayed or the distribution of the created basket could be delayed if the AP deems the distribution economically disadvantageous. This is similar to what we witnessed with Municipal Unit Investment Trusts in the early 1970s.
There has been suggestion that in the event of negative financial consequences of delivering the basket to the secondary market, the AP may Fail-to-Deliver (FTD). The delay in settlement timing for APs is explained in an article on SPDR University, run by State Street, which is only made available to Investment Advisors/Financial Professionals: http://www.spdru.com/content/do-exchange-traded-fund-settlements-frequently-fail
Securities Lending. The AP as well as secondary market investors, who may be institutional, may loan these ETFs through a securities lending program. At the AP level, especially, this creates a layer of counterparty risk that is invisible/undisclosed to the secondary market investor. On an inverse or levered instrument, this creates a second layer of counterparty risk: The first layer being swap agreements, the second layer being security lending agreements. There is a lot that can happen behind the scenes that retail investors may be unaware of, which can create extra risk for retail and extra reward for the AP.
Suitability. Investors must match suitability requirement for more advanced trades like shorting, options, futures, etc… However, there are no suitability measures or requirements for investment in ETFs. Investors who do not know what they are doing can wreak havoc on their portfolios. These instruments do not have surface differentiation.
Long-only ETFs are generally safe instruments. However, we remind investors that many of these products seek daily investment objectives. Performance over time is not guaranteed. Most of these products carry low fees and may be suitable for the person who prefers to stay passive. We urge all of our readers to read the prospectus diligently before investing. Much talk has been made about the democratization of investments brought through the ETF instrument. As with democracies, ETFs demand an informed public to function well.