I was asked by another publication to write up the difficulties of the exchange-traded market last Thursday and am sharing the gist of the article with my subscribers, with permission of course.
The selloffs in the ETP (exchange traded portfolio) market May 6 were very different depending on the size and the complexity of the ETP. But about 2/3 of the trades blocked by the NYSE and and Nasdaq since then involved exchange-traded instruments, the overwhelming majority ETPs rather than closed-end funds.
The multiple short and long ETPs behaved very differently from what the prospectuses promised. That is because these entities depend on options trades to go double bear or triple bull or whatever on some market or market category. When the options markets seize up in a period of wild volatility, the trades cannot be done.
In fact tracking error can be considerable even in normal boring non-volatility times.
Another factor in ETP tracking during a crisis is the fund’s size and liquidity. The very biggest funds were much less badly effected by the sell-off and the lack of counterparties to trades than the newer and smaller funds. By now everyone knows that the Rydex Equal Weighted S&P ETF was the one with the most busted trades (and of course also the ETP with the worst showing before the trades were cancelled.)
There is a simple reason for this. As of April 30, according to Bloomberg, which tracks this data, Rydex funds, collectively, had $67. bn under management. This sounds like a lot but in the ETF space it is pretty marginal. iShares have over $400 bn under management. State Street has $200 bn under management. Vanguard has $109 bn.
What we are facing here is a problem of asymmetrical information. Buyers of ETPs have not been worrying about the fund size. They have not considered the degree to which the ETP trading prices are supported by specialists and marketmakers. They have not concerned themselves about whether or not the authorized intermediaries have enough incentive to arbitrage between the funds’ net asset value and their trading price. With small funds the intervention costs more. So the institutional investors don’t intervene as often and the spread between the NAV and the price can grow.
However, these seemingly marginal factors seriously affect performance in a market selloff or even in a buying panic.
That means first off that the boom in press promotion and recommendation of ETOS, sometimes generated by the heavy advertising that funds engage in, will have to be reconsidered. The barrage of boosting comes from the printed press, websites, newsletters, magazines, and other sources. Nobody is questioning whether the fund can track the intended index or group of shares or bonds in market reversal.
Currently, the regulators are not considering these issues. Instead, the Securities and Exchange Commission is opening the door to so-called managed ETFs which are introducing even more risks.
There will be more scrutiny and more regulations from now on.
Another trend I forecast is that the spate of copycat funds from different competing management groups will come to an end. There will be consolidation in the ETP industry, instead of the current proliferation.
In truth, I am not that enchanted with the exchange-traded portfolios we now are being offered. My disillusionment is probably shared among savvy investors and even journalists. But for various reasons, you will not find this skepticism widely available in the financial press or on market websites. The secret reasons: ETPs do a lot of advertising. Yes, Virginia, financial journalists do not look too hard or critically at those financing their publications.
ETPs are decades old but are still being written about in “gee-whiz” articles as a new smart way to invest. A teenager is being presented as a new-born. This is not objective journalism so much as marketeering. Presenting the contrast between ETPs and traditional funds, frankly, is old news.
A spate of new media has grown up to help people pick ETPs from respectable publication groups, and from some more disreputable ones as well. The subject is written about in magazines and on websites. There are specialized reports from brokerages and advisors, on financial TV and in the press, in specialized subscription products of varying sophistication and validity. There is plenty of interest in ETPs and you can make money by catering to it. I don’t because my publication is supported by subscriptions.
However trivial it seems, the weekly exchange-traded portfolios list (for example in Barron’s) seems to get longer and longer, the alphabetization ever more irrelevant, and the type font smaller and smaller. Finding the right ETPs causes eye-strain to senior citizens like me. Despite the barrage of ads, the print for the ETPs list gets tinier and tinier.
For more information, readers can purchase the Global Investing ETF report which is for sale on our website. ETPs is a term invented by Barrons’ to cover exchange-traded notes and portfolios, not just funds.
