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Etf's:not The Investment You Might Think They Are


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'Terry Smith doesn’t like ETFs

Posted by Izabella Kaminska on May 24 12:13.

Terry Smith, City veteran, pugnacious former director of Collins Stewart and manager of the Fundsmith Equity Fund, has turned a critical eye onto one of our favourite subjects — exchange traded funds.

The view in once sentence:

ETFs – Worse than I thought

Now, the interesting thing about Smith’s tirade is that he takes things at least two steps further than the usual criticisms cast ETFs’ way (that they don’t track as they might be expected to, and in the case of synthetic ETFs, are potentially exposed to counterparty and collateral risks).

Now Smith turns his attention to the issue of the mass shorting of ETFs.

Readers might recall that Andrew Bogan of Bogan Associates raised similar concerns about a year ago, suggesting that in some cases there was a risk that an ETF might collapse if outstanding claims overwhelmed an issuer all at once.

Readers might also remember that the ETF industry (plus ETF apologists, defenders everywhere) went ballistic about the article. They argued the criticisms were stupid and that in all cases the creation and redemption mechanism assured an ETF could never collapse. In their eyes there was never a point when a provider couldn’t issue more units to overcome a short squeeze, even if the number of shorts greatly outnumber the actual number of shares outstanding of the fund.

Though, we never got a firm response about what happens in a situation when the squeeze leads to so much demand for units that it outnumbers the underlying stock of what the ETF is tracking. Also, does that mean an ETF is actually a quasi-derivative rather than a real like-for-like equivalent of the underlying its tracking, like the ETF industry claims? Though, in the case of synthetic ETFs and ETFs which use completely different collateral to the underlying, that’s arguably the case quite clearly.

There’s also the question of whether these collateralisation and synthetic practices lead to the skewing of demand for completely unrelated equities, say Japanese equities, which might otherwise see much less demand?

But back to Smith and his shorting-related concerns.

As he explains, there may be a legitimate reason to be worried after all (our emphasis):

'However, there is another and perhaps more pernicious danger with ETFs than misunderstanding or mis-selling. An ETF is in effect a hybrid vehicle which combines features of an open-ended or mutual fund with those of a closed-end fund.

They are like open-ended funds insofar as a purchaser buys or redeems so-called creation units. But they are also tradable in the secondary market, so ostensibly providing real time liquidity. Secondary trading activity brings with it the possibility that market participants will short the ETFs themselves. And there is no limit to the short selling which is impossible in an ETF in the same way that there is in an equity. In an ordinary equity, the short-selling is limited by the ability of the short sellers to borrow the stock so that they can deliver it to complete their sell bargains.

In an ETF a short seller can always rely on the process of creating shares in the ETF to ensure he can deliver. This leads to the possibility that a buyer of an ETF share is buying for a short seller and that no new share has yet been created.

The investors who buy from the short sellers don’t own a claim on the underlying basket of securities or swap in the ETF, they own a promise to deliver the ETF share given by the short-seller. The problem this causes is that as no new shares are created in the ETF by this process, the assets of the ETF may become significantly less than the outstanding cumulative buy orders would suggest.

This is a significant problem given reports that there has been short-selling up to levels of 1000% short in some ETFs. You might think that one way to overcome the risks involved in this at a stroke is for the ETF sponsor to create the shares represented by the cumulative buying interest, but this may be easier said than done.

Take an ETF like IWM in which the short interest recently exceeded 100% or $15bn. IWM invests in the Russell 2000 US small cap index. To invest $15bn in the basket of stocks involved would require about a week’s trading – and that is if the ETF creation was the sole trading in those stocks. The scope for a short squeeze is tremendous. The net result is that across the entire ETF asset class portion of the funds which ETF purchasers think have been invested in ETFs, via the creation of new shares, has in effect been lent to hedge funds.

The ETF holdings are not all backed by assets of the sort investors expect, even if they understand what the ETF is meant to do. Perhaps these little understood structural issues explain why 70% of the cancelled trades in last May’s Flash Crash were in ETFs when ETFs represent only 11% of the securities in issue in the US. Moreover, in the case of some ETFs such as PEK it is difficult to fathom what the short interest in PEK really represents as it is illegal to short China A shares.

No doubt the ETF industry will be back to debunk that view too. And we’ll be interested to see how Terry Smith handles the biteback.

As to the other issue Smith raises, we’ll have more on that soon.'

Pedro's had some interesting discussions with red karma on this issue in the past,where we've shared our doubts about various aspects of ETF investing.I wouldn't normally touch them.As the article states early on there are issues with daily repricing on the leveraged products,collateral and counterparty irisks,but these are nothing beside the issue of units being created out of thin air.It's like fractional reserve banking with ETF's and we've all seen how that worked out for a host of western banks.

It'd be great to hear how we're wrong from someone who understands the mechanics of these vehicles more intimately.

But when you look at the totality of the wealth destroying potential of the 'wealth management' industry,you can see why people are driven to stick to investments whose risks are more quantifiable.

edit to add hattip to big picture blog for the linky.



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This does not apply to all or even most ETF's. Its scaremongering by picking the dodgy ETF's then implying that its accross the board.

Take ISF (FTSE100 tracker). It has exactly tracked the ftse100 ever since it started almost 10 years ago. It is run by buying all shares in the FTSE100 depending on how much money is in the fund.

Take GBS (Gold Bullion Securities). It has exactly tracked the price of Gold for many years. It works by buying and storing gold depending on how much money is in the fund.

If I'm wrong, anyone care to explain why?

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there are those etfs that own the physical and those that use a mish mash of derivatives,equities and the underlying.

you have to check how the one you purchase is structured.whilst they shoudl track the price closely,one issue is assets/liabilites at redemption if it occurs.another is if the etf is synthetic,then how does it roll over futures efficiently if the market is normally in contango.the reality there is that at each expiry- allowing for the bid offer,the futures will have declined into expiration meanign the running costs are going to be significantly higher than a market that's normally in backwardation.

with the etf you mention,the cost of carry is the cost of storing the yellow stuff.as long as they are able to buy enough to match the inflow,there shouldn't be a problem.

problems may well arise if there's any lag in disposals/purchases as inflows/outflows change drastically,or there are no buyers in the secondary market.

If they are not able to buy enough of the yellow stuff to match inflow then I assume the price would just go up (in the ETF and in the market in general). I can however see the possibility of potential liquidity problems if there were a massive market crash.

As for the FTSE etf tracker, well it'll be as safe (and liquid) as FTSE100 shares.

In reality we could say the same about any investment unless its cash in which case you're going to lose out to inflation. But ultimately cash has risk too, as do houses. If the system caves then they're all worthless. I'll stick with my ETF's a while longer.

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Get your Bloo Loo ETF certificates here.

Spot price of anything you like issued on demand...just send the spot Price to KeepBlooLooRich, Dept HPC.

feel free to trade them with friends and family.

We dont want them back either...they are yours for life.

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