Do ETFs Pose a Threat to the Market?

The prestigious and respected Kauffman Foundation released a report critical of the current SEC rules concerning ETFs.  The story attracted a lot of attention and some good discussion.  There was some lightweight criticism of the authors, suggesting a conflict of interest.  Anyone reading the report can see that it stands on its merits.

The report raises several issues.  I see the following as the most significant, but check out the press release for the official viewpoint:

• High frequency trading is getting too much  blame for market risk.
• The ETF structure introduces excessive leverage.  Combined with illiquidity, it creates the potential for a market crash scenario.
• The ETF structure inappropriately draws in companies that are unwillingly included in a basket of stocks.  The process inteferes with optimal capital allocation and squelches IPOs.

That is the best that I can do on my preliminary reading.  It is a long and carefully documented piece of research, which the authors modestly call an "essay."  The 80+ page report has many conclusions and is too meaty for instant analysis.  Journalists must respond immediately, and they did.  There were many stories today that summarized the main conclusions.  As usual, Abnormal Returns highlighted the most important articles.

The First Cut and My Approach

On a complex story like this the initial stories are the first cut.  Here at "A Dash" I do not try to compete on breaking news.  Instead, I specialize in issues where various experts take differing positions.  I try to help individual investors, traders, and colleagues in the investment management business with the most difficult stories.

I often find that I am a day (or more) behind the news cycle, but that enables me to have a deeper perspective.  It just so happens that I will spend nine hours on airplanes in the next two days — perfect for reading and thinking about a long report.

I have already done a quick read of the report, which seems to be more than many other commentators who are reacting under time pressure, speaking in very general terms.  I have also watched TV segments and read the commentary, summarized nicely on three video pieces collected by ETF Daily news.

If you watch all three, you will understand that some are reacting in a rather confused fashion.

I looked forward to tonight's Kudlow report, where I hoped to see a debate on the specific question.  I was disappointed.   It was basically more of the same.

Let me try to summarize the issue.

The Kauffman Report cites heavily shorted ETFs and structures that substitute approximations and derivatives for the actual underlying stocks.  The defenders of the ETFs do not directly respond.  They seem to emphasize talking points about tax advantages and ease of trading.  They describe how new units are created and how those seeking the creation of a unit must deliver stock.

The participants in this debate are talking past each other.  The Kauffman group specifically cites IWM as an ETF where the short interest is not accurate reflected.  Specifically, the report implies that many more shares would need to be purchased to cover the short interest, and that the leverage is excessive.  ETF supporters do not specifically address this point, especially the failure to deliver on the part of short-sellers.  The ETF supporters emphasize the procedures for creating new units. They attribute any issues to the "secondary market" where short-selling rules may note be adequate.

My Preliminary Take

We have a typical market discussion on a complex subject:

Both sides may be truthful, but the observer gains nothing from the discussion.

My hope is that the specific IWM issue will be addressed.  The Kauffman team should be very specific in outlining how the IWM short selling poses a risk (they are already close to doing this in the report) and those responding should be specific in answering.  This is the debate that will inform investors.  I am inviting both to participate.

My preliminary conclusion is that the fault, if any, lies not with the ETF developers but with the SEC.  More later.

Full Disclosure

I have varying interests, none of which consciously affect my reporting:

• I participate in the Kauffman Foundation's efforts to support economic blogging.  They embrace wild cannons of all stripes, so no one needs to fear exclusion by taking a strong position.  For the record, I admire and support their efforts.
• I actively trade ETFs in my investor programs.
• I have a current long position in IWM.
• I am on the record as a skeptic when it comes to the potential for ETF trading to create a crash.

Summarizing — I am suprised by the Kauffman conclusions and I am looking at them with an open mind.  You should do the same.