A First Critique of Questions about ETFs


By: Ray Pellecchia
File Under: ETFs / Indexes

You might recall the commotion a couple of months weeks ago on the question of “Can an ETF Collapse?” An academic paper prompted a great deal of discussion until knowledgable people gained their voice and began explaining, in this space and others, that the concerns raised in the paper were baseless.

Well, here we go again.

Today the Kauffman Foundation issued a paper asserting that ETFs “are distorting the markets to such an extent that they are threatening the growth of new companies by effectively curtailing their access to capital.”

That’s a serious accusation from serious people at a serious institution and must be taken — you guessed it — seriously. My colleagues familiar with the ETF space are reviewing the 60-plus-page paper, and I expect we’ll be hearing from them soon.

In the meantime, Dave Nadig of Index Universe pokes what I believe are the first holes in the Kauffman paper’s argument. In all the coverage I’ve seen today of the subject — including this Cramer segment on CNBC — I haven’t heard anyone raise or respond to the point that Nadig raises here:

One of Kauffman’s many issues with ETFs is that they somehow pose a giant blowup risk for investors; that their value may simply disappear in a pile of grief and confusion. The report continuously refers to them as derivatives, a loaded word in today’s markets. They raise the specter of the government having to step in and rescue shareholders when an ETF issuer fails.

Here’s the logic of how they see an ETF issuer failing:

“In creating more ETF units, ETF sponsors are liable to purchase the underlying securities, and so the more units that are created, the greater are these purchase obligations. Yet because the underlying securities are in short supply, mounting obligations of ETF sponsors to purchase them exposes the sponsors to the risk that the cash they have on hand will be insufficient, at the sharply higher prices of the underlying securities, to cover those purchases and thus track the index.” Page 38

The levels of “Wrong!” in here are deep and profound. It reflects a serious misunderstanding of how ETFs work.

With the exception of a very few funds that rely exclusively on cash creations, ETF issuers are not “liable” to make any purchases whatsoever when new shares are created. The whole point of the ETF structure is to keep the fund (and thus the investor) from being on the hook for any transactions at all.

Kauffman mostly focuses on the iShares Russell 2000 ETF (NYSEArca: IWM), and on small-cap ETFs in general. To make new shares of IWM, an authorized participant has to deliver a specific basket of stocks to BlackRock. How does he do that? Most likely he puts in a market-on-close order to buy a big basket of stocks, which he knows—by definition—will be priced at the same closing price as represented in IWM.

If the AP can’t go buy shares of the stocks in the basket, he can’t make new shares of IWM. Assuming he can, everything works out fine: IWM gets the equity shares it needs, and the AP gets the IWM he wants.

Nowhere in this is there any risk to the existing IWM shareholder. IWM didn’t take a big pile of cash at the end of the day, and then have an obligation to race into the market tomorrow and get those stocks at any cost.

No, that nightmare scenario exists in a different vehicle: the traditional open-ended mutual fund.

More to come.

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