Editorial note: We looked at market Sentiment topping into this week’s options expirations cycle and said to ourselves, “Selves, we should be cheeseburgers in paradise instead of hanging around here waiting for the market to fall!” So we are somewhere on Barbados, not searching for Rihanna but chasing tranquility. You all are in charge. We’ll catch you up May 30! But this below to me is the most important thing to know at the moment in the stock market: How ETFs work.
Recent market volatility is, we’re told, investors one day saying “let’s sell everything because of tariffs and a trade war” and two days later “let’s buy in epic fashion because the USA is negotiating with China.”
That conforms market behavior to a fundamental explanation but omits the elephant: Exchange Traded Funds. They are 50% of market volume. They’re no side show.
Today you’ll see the way wild swings trace to how ETFs work, by creating an ETF that lets people trade houses. Sound fun?
Let’s name our ETF company after a color and something from nature. How about WhiteTree? WhiteTree is in Denver. We make Big Broker Inc., our Authorized Participant (AP) responsible for creating ETF shares, and we advertise: “Want to own residential real estate but trade it like stocks? Buy PADS!”
There’s demand (Editorial note: ETFs like STWD offer this exposure) and we tell our AP, Big Broker Inc., to provide a “Creation Basket” of titles to Denver homes as collateral, and in exchange BBI can create ETF shares to sell to the public.
We get deeds to real estate tax free. Cool! Why? It’s an “in-kind” exchange under IRS rules and SEC exemptive orders. One thing of equal value is exchanged for another. No fund turnover, no commissions (and we can charge BBI to boot!).
We don’t manage any money, just the collateral, the houses. Demand is great for PADS and analysts say, “It’s a boom in residential real estate.” We need more PADS to sell.
So we ask BBI for more collateral and BBI says, “We’re out of Denver homes. Will you take some in Minot, ND?” Sure. It’s collateral. More PADS shares, investor demand is strong, and The Housing Index, the benchmark PADS is tracking, rises.
We can’t keep up with PADS demand. We tell BBI the Creation Basket will take any housing deeds they’ve got. “We’re out,” BBI says. “How about a check for the amount of a house in Minot?”
Done! More ETF shares created. The media says WhiteTree is managing billions of investments in housing. No, we manage collateral. And we’re now writing futures on The Housing Index to boost reported ETF returns.
Home prices in Minot, ND soar. Pundits are saying, “Minot is an economic model for the nation. Everybody wants to live in Minot!”
But at WhiteTree, we’ve got a problem. Home values nationwide are rising and those capital gains taxes will be imputed to PADS shares, hurting our performance versus the benchmark. We need to get rid of capital gains, something ETF Redemption permits.
So we survey the collateral and Minot deeds have risen most. We offer a Redemption Basket to BBI: PADS shares for equal value in Minot deeds (or a cash substitute).
BBI shorts The Housing Index, borrows PADS shares from another broker, gives them to WhiteTree, which delivers Minot deeds, and BBI dumps them.
Real Estate in Minot implodes. Pundits are saying, “The economy turned. Nobody wants to live in Minot!”
This is precisely how ETFs work. Replace housing with stocks. It’s how they expand beyond the asset base and become an engine for the asset class.
Take the last two weeks. Bad times for Facebook (FB). The Tech Sector is over 25% of the S&P 500, and FB is the third largest Tech holding. It WAS the Redemption Basket, with brokers trading S&P 500 ETFs like SPY and IVV for FB and shorting FB and buying puts on Tech and FB. The market imploded.
But now ETF funds have removed capital gains via the Redemption process and instead with the Mar 31 quarter-end looming they need to true up tracking versus benchmarks.
On Monday Mar 26, the Creation Basket was full of stocks that had declined, capital gains wrung out. Brokers bought calls, bought futures on indexes, and the market before the open was set to rise over 300 points on the Dow. It gained about 700 points.
But the REASON is arbitrage opportunity between COLLATERAL for ETFs, and trading the components, and ETF shares, and options and futures on indexes. Do you see?
Yesterday, nobody showed up to buy the new ETF shares. Investors are skittish. Thus as Tuesday wore on, brokers were worried that the ETF shares they had collateralized could lose value along with the collateral they had supplied to create them. Big trouble! The market rolled over as they began selling and shorting Tech again to raise cash.
While we have theorized with PADS, what I’ve described about stocks is what we saw in the analytics we invented to track Passive Investment. Everything in the theoretical PADS scenario describes what I’ve read in ETF regulatory documents.
ETFs are like a currency backed by gold. After awhile there’s no more gold and you start backing the currency with something else – or nothing, as is the case today. The creation of money drives up prices, the rise of which is misconstrued to be economic growth.
ETFs are not rights to stocks via pooled investments. They are substitutes you buy from brokers. As WhiteTree manages no ETF money, so it is with the big ETF sponsors.
The good thing about ETFs is they allow more money access to a finite asset class. But that’s the bad news too. Overextension of assets inevitably leads to bubbles which leads to popping bubbles.
Volatility since February has roiled the value of ETF collateral. Managing collateral exposure is wholly different than investing, and why inexplicable behavior is becoming more common in stocks. You can see with PADS how complicated resolving this tangle might prove to be. It’s the age-old lesson about derivatives.