Is there a problem with Exchange Traded Funds?
November 15, 2010 5:09 PM   Subscribe

A recent report (pdf) from the Kauffman foundation on Exchange Traded Funds (ETFs) has suggested that these investment vehicles may be contributing to a number of problems in the stock market (summary, video).

In particular, ETFs made up 65% of the canceled trades of the May 6th flash crash, appear to be driving highly correlated stock movements, and are sold short at alarming frequencies, leading some to question if an ETF could collapse. While many dispute these claims, others ask if ETFs are the new CDOs.

At the very least, it seems clear that ETFs are more complicated entities than the simple market indexes they are supposed to mirror.
posted by pombe (21 comments total) 7 users marked this as a favorite
 
And, perhaps, they are ruining the IPO market.
posted by procrastination at 5:20 PM on November 15, 2010 [3 favorites]


I've been possibly over-invested in S&P 500 index funds for a while. There's something attractive about not having to constantly manage your money, and not having investment fees from investment churn destroy your inflation adjusted profits. That said, I don't react quickly enough to even slow economic changes, because I'm not in the habit of double checking all the time.
posted by BrotherCaine at 5:29 PM on November 15, 2010


I am not an economist or stock broker - but it seems to me that any investment in a derivative instrument has an element of risk that investing in stocks does not have, namely that the only way to judge to health of the instrument is by it's past performance. When you invest in stocks, you at least understand what the underlying value of the stock is based on, and can make fairly educated guesses on how the stock will perform in the future.

While derivatives seek to insulate themselves from market volatility and maximize returns, it is simply not possible to do that - you trade one type of volatility for another. So it's all about maximizing returns. Couple that with cheaper brokerage fee structures, tax advantages, and the investors are sure to flock there. Then, when the SHTF, you have greater volatility - the bigger they come, the harder they fall.

The stock market comes to resemble the craps table more each day. Only we aren't playing at the craps table, we are playing at a table where the results are based on the aggregate of a number of craps tables that are being played elsewhere.
posted by Xoebe at 6:16 PM on November 15, 2010


So they are trying to deflect attention from High Frequency Trading and derivatives and put the blame on the one possible route (other than precious metals) that many have to try to shield their money from QE2....

WOW... someone has brass balls.
posted by MikeWarot at 6:19 PM on November 15, 2010


I'm not so sure about the claim in the IPO article that people just aren't picking stocks anymore. Little-guy retail was never that important and never that good at picking winners. If some players are out of the price-discovery game, that should leave free money for those who research companies professionally.
posted by a robot made out of meat at 6:51 PM on November 15, 2010


Derivatives? Not sure why you're talking about derivatives in a thread about ETFs, most ETFs (excluding the gimmicky 2x long, 2x short, 4x long, etc. funds) hold the stocks in the index that they track. It's the same thing as investing in an index mutual fund, which I don't think anyone would refer to as a derivative.
posted by indubitable at 7:42 PM on November 15, 2010 [1 favorite]


ETFs provide an interesting arbitrage opportunity, since they encourage the mispricing of smaller securities which are not moving in the same direction (or in the same direction at a different rate) from the broad market.
posted by unSane at 8:36 PM on November 15, 2010 [1 favorite]


"And, perhaps, they are ruining the IPO market."

Which is bad news for Kauffman...
posted by gen at 8:38 PM on November 15, 2010


The SPY and other index ETFs are much more complicated than simple index holding funds. It isn't like if you buy 1000 shares of SPY, the company behind it goes out and purchases % of all the S&P 500 stocks in the same way. They do a lot of complicated trades and options to mirror the return of the S&P 500 and have that as their stated obejctive, but if you read the fine print you find out its a lot more complicated. These things track the S&P 500 because we mostly don't look behind the curtain. No one has a sense of how to quantify the risk between holding actual members of the SP500 vs. SPY. If we under-estimated those risks as was done in mortgages, we're screwed.
posted by humanfont at 8:49 PM on November 15, 2010


I am using derivative in the broad sense. To quote from the last link in the FPP:
There is nevertheless no doubting an ETF is a “derivative”.

ETFs are very much like mutual funds, and very different. From what I gather, the rules for what an ETF is are pretty much all over the place. The value of an ETF may have very little to do with what it is nominally indexed to.

Personally I don't find this problematic. If people want to invest in these, fine. The problem is, as we saw in the 80's and more recently in the late 00's, the quantity of investment becomes problematic when large funds go *poof* and everyone goes *poop* in their pants.
posted by Xoebe at 9:11 PM on November 15, 2010


ETFs are absolutely derivatives. They are meant to track the movement of the underlying security/ies on a daily basis, and they do this by using an exotic mix of derivatives. They do NOT track the long term performance of the underlyings accurately due to the built-in costs of rebalancing every day.
posted by unSane at 9:50 PM on November 15, 2010


It isn't like if you buy 1000 shares of SPY, the company behind it goes out and purchases % of all the S&P 500 stocks in the same way.
posted by humanfont


From Vanguard's website regarding their S&P 500 tracker VOO:

"Vanguard S&P 500 ETF seeks to track the investment performance of the S&P 500 Index, a widely recognized benchmark of U.S. stock market performance that is dominated by the stocks of large U.S. companies. Vanguard S&P 500 ETF is an exchange-traded share class of Vanguard 500 Index Fund. Using full replication, the portfolio holds all stocks in the same capitalization weighting as the index."

Of course how and when they buy and sell can affect whether or not there is variance with the benchmark, and yes they do have fine print that allows them to do other things or use derivatives and such, but it's mostly exactly what it says on the tin.

ETFs inject a great deal of stability into the markets as well (at least the indexed ones).
posted by haveanicesummer at 9:57 PM on November 15, 2010


They do NOT track the long term performance of the underlyings accurately due to the built-in costs of rebalancing every day.
posted by unSane


SPY 10 yr performance according to Google Finance is -12.15% while the S&P is down 12.32%. That's pretty close (and on the good side of close). Since inception it's 1 percent off, and again it's a profitable 1%.
posted by haveanicesummer at 10:01 PM on November 15, 2010


Now go look at SKF or FAZ.
posted by unSane at 10:09 PM on November 15, 2010


Yeah I agree, those Ultrashorts and other such strategy ETFs are crazy and volatile, so you're definitely right if you're talking about those. Some of them aren't even meant to be held, as they only even intend to reflect performance in the short term (and have done a pretty bad job of it). If someone really could make a 2X long S&P 500 that performed in line with the index they'd be minting money, but of course you can't really do that, you have to fake it. A lot of those strategy ETFs have been underperforming on the upside and then doubling their losses on the down days. The big proponents of the low cost index ETFs have been really against these complicated managed ones, as they have much higher fee structures as well, so you're paying more for a great deal of potential volatility and a bunch of extra risk.

I suppose if you find some really obviously flawed ETFs, there'd be some money to be made shorting them.
posted by haveanicesummer at 11:09 PM on November 15, 2010


unSane: ETFs are absolutely derivatives. They are meant to track the movement of the underlying security/ies on a daily basis, and they do this by using an exotic mix of derivatives.

Isn't it the case that index ETFs like SPY and VOO represent funds that are composed entirely of underlying assets? You can easily check that the holdings of, say, VOO are pretty much just shares in the S&P 500 with not an exotic derivative in sight. Certainly, there exist many ETFs that are composed mostly, if not entirely, of derivatives (e.g.: the 2x, 3x, and Ultra series). But, I'm not sure that it's fair to claim that all ETFs are structured in this way.
posted by mhum at 11:10 PM on November 15, 2010


humanfront: These things track the S&P 500 because we mostly don't look behind the curtain.

Well, as I mention above, you can "look behind the curtain" of Vanguard's S&P 500 ETF VOO here. You can look at SPY's holdings here. IVV's holdings are here. In all three cases, it's pretty much the case that they are holding exactly the 500 (or so) stocks in the S&P 500 index. And why wouldn't they? The easiest (and lowest cost) way to mimic exactly the return of the S&P 500 is to hold exactly those stocks.

The leveraged 2x, 3x, and Ultra ETFs are trying to exceed (and/or reverse) the returns of the S&P 500. In these cases, they definitely have use to derivatives and/or leverage to obtain those kinds of results.
posted by mhum at 11:55 PM on November 15, 2010


"We believe that investors are not sufficiently informed about their role in the marketplace for short sellers because terms like "hypothentication agreements" and "opt-out ideas" mask the true economics about which all investors should be informed. If a broker who does not own and merely custodies a stock for the owner can earn 30 percent in interest payments a year to lend that security (using Tesla as an example) to a short seller, why should the investor not share in that gain? It is the investor's share of ownership being used to bet against his very interests with absolutely no remuneration."


Forgive my insufficiently informed investor attitude, but how does this differ from mutual funds?
posted by pwnguin at 11:19 AM on November 16, 2010 [1 favorite]


I think its funny that people think when they send vanguard in their dollar that vanguard goes out and buys a slice of the S&P 500. That's not how this stuff works. It couldn't work like that.

Forgive my insufficiently informed investor attitude, but how does this differ from mutual funds?

In the case of low-fee passive investments one of the ways the manager makes money given the very low fees is from security lending. You as a shareholder don't see the benefit from those activities. However in the case of the something like the S&P 500 rare is the stock that has a borrow high enough that the benefit ends up being measured in more than basis points. I mean basis points are still material but I think that quote overstates the case - and if you reversed the situation you would either force fees higher - or more likely make the industry even more concentrated as you increase the incremental returns to scale. Which actually isn't a bad thing if fees keep getting lower (because incremental profitability is tremendous for these sort of businesses). Basically its not totally clear if someone is getting screwed by the current setup.
posted by JPD at 4:59 AM on November 17, 2010


Well, as I mention above, you can "look behind the curtain" of Vanguard's S&P 500 ETF VOO here. You can look at SPY's holdings here. IVV's holdings are here.

Not the disclaimer "the above list may not be representative of all holdings.
posted by humanfont at 6:18 AM on November 17, 2010


not to mention that the word "own" is always up for interpretation in the world of finance.

The easiest (and lowest cost) way to mimic exactly the return of the S&P 500 is to hold exactly those stocks.

This is manifestly untrue.
posted by JPD at 6:42 AM on November 17, 2010


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