FX Effects

It’s all about the Benjamins, baby.

What I mean is, Forex (FX) is the world’s most active trading market, with some $5 trillion daily in currencies changing hands on a decentralized global data network.  It can teach us how to think about the effects of Exchange-Traded Funds (ETFs) on stocks.

It’s a 24-hour-a-day market, is FX. And by the way, I’m moderating a panel called “24 Hours of Trading: What You Should Know About Market Structure” Friday at the NIRI Silicon Valley Spring Seminar.

We’re the closing panel, and happy hour follows, so come learn from our outstanding guests and stay for a beverage.  Every investor-relations professional should know how the stock market works now, because the reason we have jobs is the stock market.

Back to our thesis, ETFs trade like currencies. So they’ll have the motivation found in currency-trading.

Currencies trade in pairs, like the dollar/euro, and transactions are in large defined blocks. Most FX trades are bets that a currency will move up or down, producing a profit.  It’s always a pair – if you’re selling a currency, you’re buying another.

The transactions that create ETFs are also in blocks, though they occur off the stock market between ETF creators and broker-dealers. If you want to know more, read this.

The pair in ETF trading is stocks. In fact, ETFs by rule must have what the SEC terms an “arbitrage mechanism.” That’s esoterica meaning there are two markets for ETFs, fostering different prices for the same thing.  ETFs are created wholesale off-market in big blocks and sold retail on the market in small pieces.

The big profit opportunity, though, as with currencies, is in the pair, the underlying stocks. They move apart, creating profit opportunities. Last week, the average spread between the stocks comprising a sector and the ETF for trading that sector was 57 basis points (we wrote about these spreads).

No wonder ETFs are cheap for investors. You can make as much trading them in a week as Active investment managers charge for managing portfolios for a year (SEC: why do ETFs charge a management fee at all, since they don’t manage customer money?).

Let me use an analogy. Picture a gold-backed currency. There’s a pile of gold. There’s a pile of money representing the gold. To have more money, there must be more gold.

Of course, all gold-backed currencies have dropped the gold, because the pile of gold, which is hard to get, fails to pace the easy creation of paper.

ETFs are stock-backed currencies. There are piles of stocks off the market. There are piles of ETF shares issued into the stock market that represent the value of stocks.

Managing collateral isn’t really investment. The head of equities for a big global asset manager told me they’d gotten into ETFs because of a decade-long rout of assets from stock-picking funds.

He said it’s a completely different endeavor. There are no customer accounts to maintain.  The focus is tax-efficiency, managing collateral, constructing the basket, relationships with Authorized Participants who create ETF shares.

He said, “And then what do you need IR (investor relations) for?” They’re not picking investments. They’re efficiently managing the gold backing the currency.

Nasdaq CEO Adena Friedman told CNBC’s Squawk Box Monday, marking the 20th anniversary of the QQQ, “If there’s too much index investing and not enough individual investing, then there become arbitrage opportunities.”

She meant “arbitrage opportunity” not as a good thing but as a consequence of too much passive money.  The focus of the market shifts to spreads and away from fundamentals. The QQQ is a big success. But ETFs have now exploded.

Much of the volume in ETFs is arbitrage, because the arbitrage mechanism is the only way they can be priced – exactly like currencies now.

Investors and public companies act and think and speak as though fundamentals and economic facts are driving the market. The more the market shifts toward collateral and currency, the less fundamentals play a pricing role.  This is how ETFs are giving stocks characteristics of an FX market where the motivation is profit on short-term spreads.

Like currencies, changes in supplies are inflationary or deflationary. Consider how hard it is for countries to reduce supplies of currency.  Whenever they try, prices fall. Falling prices produce recessions. So instead countries don’t shrink currency supplies and we have catastrophic economic crises.

Are ETF shares keeping pace with the assets backing them? It’s a question we should answer. And IR folks, your relevance in this market is as chief intelligence officer measuring all the forces behind equity value. You can’t remain just the storyteller.