Mispricing

If the stock market reflects all information currently known, why are buyout deals nearly always done at a premium to market price?

“Because, Quast, deals involve proprietary pricing models that account for synergies.”

Sure. But I want you to think about prices. The Wall Street Journal recently reported that Blackrock cut fees on several exchange-traded funds (ETFs) to three cents per $100 of assets annually.

Low fees appeal. But how are they doing it?  After all, ETFs are notoriously high-turnover vehicles. The Investment Company Institute says conventional institutions sell about 42% of asset annually. Data from ETF Database showed ETF turnover of 2,200% annually, and leveraged ETFs using derivatives to achieve returns turning over a shocking 164 times more than underlying assets. At that rate, a $1 billion ETF could trade $164 billion of shares in a year. Tally your volume over the trailing year and divide by your average market-cap and it’s probably 1-3 times.

It’s an axiom of financial markets that churning assets consumes returns. So how can ETFs be low-cost vehicles? In June 2011, Financial Times of London writer Isabella Kiminska brilliantly observed that ETFs are built around what she termed “manufactured arbitrage.” If ETFs aren’t making money on fees it’s because they make it elsewhere.

In fact shares of ETFs represent something that exists elsewhere. Every day, ETF sponsors like Invesco and Blackrock give their brokerage agents called authorized participants (APs) a creation basket, a list of securities or other assets held by the ETF. The AP assembles this list for the ETF and receives in kind a bunch of paper – a chunk of ETF shares to sell. The AP may substitute cash for the creation basket too.

APs thus always know before everyone else whether demand is rising or falling. An AP could buy underlying securities (or borrow them) and supply them to the ETF, and then sell the ETF shares, and if the ETF is later discounted to the underlying securities, buy the ETF shares and redeem them to the ETF. The ETF industry in fact touts this continual arbitrage opportunity in ETFs as a key efficiency feature.

Actually, it explains why ETFs have low costs. There’s a lot of money in trading paper back and forth while not having to compete with anybody else.  ETFs and APs are a closed market that collectively is always a step ahead.

High-frequency traders (HFT) also claim to offer efficacy through frenzy.  Modern Markets Initiative, the HFT industry lobbying group, says HFT fuels “market efficiency” because automated markets reduce costs, enhance access and increase competition. It defies logic to propose you can reduce costs by doing more of something (politicians often make this claim, which future financial outcomes refute).

“Market efficiency” is a euphemism for arbitrage. We’ve been led to believe that because arbitrage occurs where pricing gaps form, created arbitrage will eliminate gaps. No, what goes away are real prices.

There’s yet a third instance of this pricing contradiction amid the market’s core building blocks. Reg NMS capped the fee for buying shares at $0.30 yet all three big exchanges pay sellers more than that. The NYSE pays its best trading customers about $0.34 per hundred traded shares, the Nasdaq about the same. BATS Group pays top customers in thinly traded stocks $0.45 per hundred shares to sell while charging just $0.25 per hundred to buy.  All three will pay extra to traders active in both stocks and derivatives, the latter called “Tape B” securities denoting the facility for most derivatives trades.

Why are they paying more than they charge? Arbitrage, here between the trades and the value of data. By paying traders to set prices, data become more valuable. All three sell feeds and technology to brokers and traders for sums ranging from $5,000 monthly for a cabinet in a collocation facility to $100,000 monthly for an enterprise data feed.

What drives most of the volume in markets? ETFs are behind disproportionate amounts. HFT gets paid to set prices.  And APs – the big prime brokers like Goldman Sachs and Morgan Stanley – drive half the market volume. A key motivation across the three is profiting on spreads.

These gaps aren’t occurring through information asymmetry or market inefficiencies but are manufactured through the form ETFs take as derivatives and through the fee-structure and function of the National Market System.

No wonder there’s a premium on go-private deals.  They cut out the middle men arbitraging away real prices. And no wonder it’s so difficult to match the market to reality. It’s deliberately and mechanically manufacturing prices. That’s apparent when one understands ETFs, HFT and exchange market-access fees.