ETFs: A Derivative By Any Other Name

ETFs are not just liquid, safe and efficient; they are a force for democratization. Wait, sorry—not ETFs That was the argument in favor of mortgage-backed securities (MBS). 

History doesn't repeat itself, Mark Twain is supposed to have said, but it does rhyme. Exchange-traded funds differ from mortgage-backed securities in just about every detail, but in several important ways, the hottest three-letter derivative of 2017 recalls the one that helped send the economy into a tailspin in 2007.

As Harold Bradley and Robert Litan wrote in a Kauffman Foundation report on the potential for future market disruptions, "we are worried that the increasing packaging of securities is looking a lot like the financial engineering that created the mortgage mess." Measured by assets, the ETF market has almost tripled since that report was published in 2010.

The Liquidity Promise

Boosters in the early years of the new millennium painted MBSs as the American Dream, Securitized: "When you invest in mortgage-backed securities," Piper Jaffray wrote in 2005. "You help lower the cost of financing a home and make housing more affordable for many Americans."

Today the pitch for ETFs carries a similar power-to-the-people ring: "The tremendous growth of the ETF lineup has democratized the business of investing," ETF Database writes, "opening up investment strategies and entire asset classes that have historically been accessible only to the largest and most sophisticated of investors."

They're not wrong. Using the SPDR S&P 500 ETF (SPY), retail investors can—if they want to—be in and out of a $235 broad-market position in a matter of seconds, paying just $10 or so in trading fees. Not so long ago that would have been unthinkable. Building up a position that even remotely mirrored a major equity benchmark would have required the purchase of thousands of shares in hundreds of companies, involving a massive amount of time and capital. 

Allowing regular investors to approximate investment in the broad market—to index—was Jack Bogle's contribution in the 1970s, but mutual funds charge high fees and don't trade on exchanges. No checking the price of the S&P 500 at 10:36.03 and closing a trade at 10:36.05. You'll find out what your shares sold for after the close. ETFs also provide tax advantages over their mutual fund cousins.

Small wonder ETFs are so popular. BlackRock estimates that assets in U.S. exchange-traded products, which include ETFs and exchange-traded notes or ETNs (which are unsecured debt instruments), have more than doubled since 2012 to over $2.7 trillion. 

But perhaps we should be suspicious of this ease, transparency, and liquidity. As Bradley and Litan wrote in 2010, "One unfortunate tendency on Wall Street that seems to happen over and over again is that 'innovators' create products promising unlimited liquidity—trading ease—for inherently costly, difficult-to-trade securities." The machinery required to construct an ETF is hulking, complex, and expensive. That it works during good times is impressive; that it can break down during bad times is hardly surprising.

The August 2015 Flash Crash

On August 11, 2015, China's central bank adjusted its exchange rate regime to allow the market more say in determining the yuan's value. The currency plunged by nearly 2.8% against the dollar in two days (belying Trump's assertions that it was undervalued) and sparked a chain reaction that, on August 24, struck equity markets around the world. The S&P 500 closed down 3.9% after hitting an interday low of down 5.3%.

These market losses sent a gaggle of the world's most heavily traded ETFs into a tailspin. The iShares Core S&P 500 ETF (IVV) closed down 4.2%, a bit off from the index it was supposed to track. But rather than hitting an intraday low of around 5% below the prior close, it dropped 25.9%. 

IVV was designed to track the most liquid equities in the world—U.S. blue chips—but the market-making machinery broke down. The potential for malfunction is even more severe when the underlying assets are themselves illiquid: seldom-traded corporate bonds and small-cap stocks, for example.

According to Barron's Chris Dietrich, the August 24 incident was largely due to circuit breakers that halted trading in individual stocks, widening their bid-ask spreads. Trading in hundreds of ETFs was also halted; unable to trade stocks or ETFs for minutes at a time, authorized participants were prevented from performing the arbitrage that keeps ETF and index prices in line.

Since, according to this explanation, regulatory measures are largely to blame for the malfunction, there is a chance that regulatory changes could fix the issue. But this fix would inevitably cause problems elsewhere; the circuit breakers themselves were designed to prevent another May 6, 2010. Following that flash crash, 65% of canceled trades were of exchange-traded products. 

Systemic Risks

If the risks were limited to ETFs themselves, the problem might not be so severe. Using limit orders rather than market orders mitigates the risks associated with short-lived swoons, and in any case, investors have every right to trade risky instruments. But as Dietrich also pointed out, quoting Credit Suisse, ETFs accounted for 42% of the value of trading on U.S. exchanges on August 24, 2015. 

The growing clout of ETFs could signal the triumph of the passive side of the passive-active investing debate: since stock-pickers tend to underperform indices, the logic goes, why not just invest in the benchmark? This outlook has its critics. Nobel Prize-winning economist Robert Schiller has questioned the circular logic of passive investing: "So people say, 'I'm not going to try to beat the market. The market is all-knowing.' But how in the world can the market be all-knowing, if nobody is trying—well, not as many people—are trying to beat it?"

The reality, however, is that ETFs—even those that track broad-market indices—are not being used passively. They account for 42% of trading—not holding—by value, and SPY is the world's most traded security.

The passive-active debate "doesn't even exist if you talk to a professional," Tony Rochte—the president of Fidelity Investments' SelectCo, who previously worked at State Street and iShares—told Barron's in March. "Financial advisors view themselves as architects using building blocks, index products alongside actively managed funds."

More importantly, ETFs are far from passive, in the sense that they increasingly affect the securities they are supposed simply to track. As Bradley and Litan put it, ETFs are becoming "the proverbial tail that wags the market." 

Barron's Randall Forsyth has argued this was the case with the Guggenheim Solar ETF (TAN) and a shady Hong Kong solar panel manufacturer, Hanergy Thin Film Group. As the stock rose in price, its market cap increased, giving it a larger weighting in TAN's portfolio, requiring Guggenheim to buy more shares, driving the price further up, and so on—until the stock plummeted, bringing the ETF's shares down with it.

More worrying than an ETF's ability to pump up underlying securities through buying is its ability to deflate them: "selling of ETFs can mutate rapidly into the destruction of the value of underlying stocks," Bradley and Litan wrote. During a "massive exit from the market," they added:

The underlying securities in broad indexes, and most especially in small capitalization or industry specific indexes, can be drowned in a tsunami of derivative arbitrage selling, very likely in a disorderly fashion, by the stampede away from the ETFs of hedge funds, portfolio insurance sellers (e.g. institutions), and retail investors. Put simply, the marketing strategies that sell ETFs as frictionless and unconstrained investment vehicles do not account for the inherent difficulty of trading the securities within these packages.

The market may already have gotten a taste of this phenomenon on August 24, 2015. While IVV and other ETFs with liquid blue chip holdings dropped far lower than the broad market, so did many of the liquid blue chips themselves.

IVV's top ten holdings all hit intraday lows below the S&P 500's 5% drop: Apple Inc. (AAPL) fell 13%; Microsoft Corp. (MSFT), 8%; Inc. (AMZN), 9%; Facebook Inc. (FB), 16%; Exxon Mobil Corp. (XOM), 8%; Johnson & Johnson (JNJ), 14%; Berkshire Hathaway Inc. (BRK-A), 6%; JPMorgan Chase & Co. (JPM), 21%; Alphabet Inc. (GOOG), 8%; General Electric Co. (GE), 21%. The extent to which these stocks were being traded via free-falling derivative instruments may help explain their declines. 

ETFs' role as intermediaries between investors and investments is projected to grow: based on survey results, PwC predicted in 2015 that assets invested in ETFs would at least double by 2020. Stories such as IVV's and TAN's are likely to become more common and have effects that go well beyond individual stocks and ETFs.

The Big 3 Economy

In one important way, though, ETFs are indeed passive. The Big Three providers—BlackRock Inc. (BLK), the Vanguard Group Inc. and State Street Corp. (STT), which collectively control 71% of the ETF market—have bought up sizeable stakes in corporate America in order to satisfy demand for their wares. Just how sizeable emerges in a recent working paper by Jan Fichtner, Eelke Heemskerk and Javier Garcia-Bernardo of the University of Amsterdam.

They find that, taken together, the Big Three are the largest shareholder in 40% of U.S. listed firms. Calculated by market capitalization, the Big Three are the biggest shareholder in firms representing 77.9% of the U.S. public market. BlackRock has a 5% stake or greater in 2,632 companies around the world, most of them in the U.S. The figure for Vanguard is 1,855. 

The image below maps companies' "potential shareholder power," based on the authors' calculations: "the Big Three occupy a position of unrivaled potential power over corporate America."

Source: Fichtner, Heemskerk and Garcia-Bernardo.

The Economist has labeled this quiet accumulation of immense corporate heft by a few companies "stealth socialism." That it may be, though the sentiment recalls now-quaint-sounding accusations that Jack Bogle's index investing was "un-American," and in fact, the result of this concentration is anything but central planning.

For several reasons, fund managers tend to use their shares to vote along with management—in over 90% of cases, the authors calculate. Executives are therefore assured that a huge bloc of shares—the Big Three's mean holding in 1,662 public U.S. firms is 17.6%—will most likely vote their way, including on generous compensation packages. Nor is that the only effect of increasing the concentration of ownership. According to José Azar, Martin Schmalz, and Isabel Tecu, it has pushed up airline ticket prices by 3-7%.

The Committee

The ultimate irony, however, is that some of the indices that organize these massive flows of passively managed capital are not themselves passive. The S&P 500, for example, is not a rules-based index at the end of the day; its components are actively chosen by an S&P Dow Jones Indices committee that, as the committee's managing director and Chair David Blitzer wrote in 2014, has "some discretion in selecting stocks or responding to market events." 

Some investors are livid that a tiny group of unknown decision-makers sits at the top of the passive economy. DoubleLine Capital LP founder Jeffrey Gundlach told CNBC on May 8:

If you're hiring an active manager you're supposed to do due diligence. You're supposed to look into their selection process, you're supposed to look into their research, how they make decisions. People are blindly handing over their money to an investment committee they know nothing about. It's really almost a breach of fiduciary duty on the part of institutional asset pools to be going to passive without understanding what exactly is the day-to-day.

A Generation of Derivative Investors

A proliferation of apps is promising to democratize investing by making it easy and inexpensive. Robinhood, Betterment, Stash, and Acorns are just a few. Friends of mine who do not spend their working hours researching financial arcana sometimes ask me if I would recommend using them, and I tell them that I would be wary of allocating all of my investing capital to ETFs.

Occasionally they have some idea of what that acronym means. Usually, they have none. They invariably protest that the XYZ app invests in a mix of stocks and bonds, which it does, through derivatives the user hardly ever understands.

Even those who hire a financial adviser for an actively managed fund may discover that they own only ETFs, or even just one. Selling such a strategy as "diversification" does not stand up to scrutiny.

Before the financial crisis, a widespread mentality associated "mortgage-backed securities" with "mortgages"—safe, dependable, even patriotic investments in durable assets—and glided over the "backed securities" bit. Today we think of MBSs as derivatives, not necessarily malignant, but not necessarily what they purport to be either. We should break the habit of hearing "exchange-traded funds" and thinking "stocks and bonds" before a crisis breaks it for us.

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