Tagged: ETF creation and redemption

Blocking Volatility

Boo!

As the market raged high and low, so did Karen and I this week, from high in the Rockies where we saw John Denver’s fire in the sky over the Gore Range, down to Scottsdale and the Arizona desert’s 80-degree Oct 30 sunset over the Phoenician (a respite as my birthday is…wait for it…Oct 31).

Markets rise and fall.  We’re overdue for setbacks.  It doesn’t mean we’ll have them, but it’s vital that we understand market mechanics behind gyrations. Sure, there’s human nature. Fear and greed. But whose fear or greed?

Regulators and exchanges are tussling over fees on data and trades.  There’s a proposed SEC study that’ll examine transaction fees, costs imposed by exchanges for trading. Regulation National Market System caps them at $0.30/100 shares, or a third of a penny per share, which traders call “30 mils.”

The NYSE has proposed lowering the cap to $0.10/100, or a tenth of a penny per share, or 10 mils. Did you know there’s a booming market where brokers routinely pay eight cents per share or $8.00/100 shares?

What market? Exchange-Traded Funds (ETFs).

We’re told that one day the market is plunging on trade fears, poor earnings, geopolitics, whatever. And the next, it surges 430 points on…the reversal of fears. If you find these explanations irrational, you’re not alone, and you have reason for skepticism.

There’s a better explanation.

Let’s tie fees and market volatility together. At right is an image from the iShares Core MSCI EAFE ETF (CBOE:IEFA) prospectus showing the size of a standard creation Unit and the cost to brokers for creating one.  Divide the standard Unit of 200,000 shares by the usual cost to create one Unit, $15,000, and it’s $0.08/share (rounded up). Mathematically, that’s 2,600% higher than the Reg NMS fee cap.

Understand: brokers provide collateral – in this case $12.5 million of stocks, cash, or a combination – for the right to create 200,000 ETF shares to sell to the public.

Why are brokers willing to pay $8.00/100 to create ETF shares when they rail at paying $0.30/100 – or a lot less – in the stock market?

Because ETF shares are created in massive blocks off-market without competition. Picture buying a giant roll of paper privately, turning it into confetti via a shredder, and selling each scrap for a proportionate penny more than you paid for the whole roll.

The average trade-size for brokers creating IEFA shares is 200,000 shares.  The average trade-size in the stock market where you and I buy IEFA or any other stock is 167 shares (50-day average, ModernIR data).  Do the math on that ratio.

ETF market-makers are pursuing a realtime, high-speed version of the corporate-raider model. Buy something big and split it into pieces worth more than the sum of the parts.

In a rising market, it’s awesome.  These creations in 200,000-share blocks I’ve just described are running at nearly $400 billion every MONTH. Create in blocks, shred, mark up. ETF demand drives up all stocks. Everybody wins.

What happens in a DOWN market?

Big brokers are exchanging your stocks, public companies, as collateral for the right to create and sell ETF shares.  Suppose nobody shows up to buy ETF shares.  What brokers swapped to create ETF shares is suddenly worth less, not more, than the shredded value of the sum of the parts. So to speak.

Without ETF flows to drive up it up, the collateral – shares of stocks – plunges in value.

The market devolves into desperate tactical trading warfare to offset losses. Brokers dump other securities, short stocks, buy hedges. Stocks gyrate, and the blame goes to trade, Trump, earnings, pick your poison.

How do I know what I’ve described is correct?  Follow the money. The leviathan in the US equity market today is creating and redeeming ETF shares. It’s hundreds of billions of dollars monthly, versus smatterings of actual fund-flows. You don’t see it because it’s not counted as fund turnover.

But it fits once you grasp the weird way the market’s last big block market is fostering volatility.

What’s ahead? If losses have been sorted, we’ll settle down in this transition from Halloween to November. Our data are still scary.  We may have more ghouls to flush out.

Reactively Passive

As stocks fell last week, pundits declared that interest rates and trade fears had shaken confidence. Yesterday as the Dow Jones Industrial Average zoomed 540 points, earnings, they declaimed, had brought investors rushing back. Oh, and easing trade tensions.

Didn’t we know corporate profits would be up 20% on tax cuts?

Rational factors affect stocks. But often these convenient explanations are offered afterward, and few observers seem to look at the data surrounding investment behavior.

The first image here with data from the Investment Company Institute’s 2018 Factbook shows the staggering shift from active to passive funds over the past decade. It debunks most market reporting claiming rational thought is reactively propelling markets.

A fallacy that lacks comprehension of how passive money behaves is that it rides the coattails of rational money (In fact Active investors are closet indexing with ETFs). If your stock is 1% of a weighted index fund, and shares rise faster than other components and become 1.2%, sooner or later the fund must rebalance or slip out of compliance.

If equities are meant to be 40% of a targICI Data from 2018 Factbook - Active to Passive shiftet-date fund and become 50%, the fund will rebalance.  We see the patterns, most times at month-ends and quarter-ends, and around monthly expirations when options, futures, forwards, repurchases and other derivatives used widely by investors, market-makers and fund managers must be recalibrated.

The biggest culprit is Exchange Traded Funds.

We’re told by Blackrock, Vanguard and State Street that ETFs have little turnover.  Should we believe money pours into markets but does nothing? It cannot simultaneously be true that trillions of dollars shift to ETFs and true that ETFs don’t invest it.

Unless ETFs don’t buy and sell things. In which case, what are ETFs?

I looked at the turnover rate in the last prospectus for SPY from State Street, the largest and oldest ETF. The fund says it bought or sold just 3% of its $242 billion of assets.

But turnover is footnoted: “Portfolio turnover rate excludes securities received or delivered from in-kind processing of creations or redemptions of units.”

Huh. Creations and redemptions?  We researched it (as you already know!).

Creations and redemptions, it turns out, are tax-free, commission-free, off-market block transactions between large brokers and ETF creators like Blackrock.  The broker supplies collateral such as stocks or cash and receives in-kind rights to create and sell ETF shares.

Then trillions of investment dollars buy these collateralized stock substitutes, setting stocks afire. If investors sell ETFs, brokers buy and return them to Blackrock to get collateral back. Wash, rinse, repeat.

Blackrock makes money as the rush of investors into ETFs drives up the value of the underlying collateral (gotten by brokers where?), and by minimizing taxes.

For instance, under rules for ETFs, if your stock has gone way up, Blackrock will put your shares in the redemption basket to trade for an equal value of ETF shares from, say, Morgan Stanley, which then can sell and short your stock, which plunges.

Blackrock sheds associated capital gains.  Morgan Stanley at some future point will cover or buy your shares and return them to Blackrock for the right to create more ETF shares offering exposure to – whatever, the S&P 500, a sector ETF, a market-cap ETF.

These transactions are occurring in the hundreds of billions of dollars monthly, none of it recorded as fund turnover.

If creations and redemptions were counted for SPY, its turnover rate would be 165%, not 3%. SPY created and redeemed well more than $400 billion, nearly double its total assets, in the most recent full year.

As of Aug 2018, nearly $2.9 TRILLION of these transactions has occurred – all effectively commission-free and tax-free for Blackrock, Vanguard and State Street (but not for the end consumers of ETFs, who pay taxes and commissions).

Continually, brokers try to profit on differing prices for collateral and ETF shares, and ETF managers try to wash out capital gains, removing overvalued collateral and bringing in undervalued collateral (the reason you and peers diverge).

The relentless creation/redemption tides swing stocks, and human beings then cast about for explanations like interest rates or trade fears – or wait, trade fears have eased! The market rallies!

Tech Sector behaviors Sep-Oct 2018This is what it looks like in the Tech sector. We saw the same pattern at the same time in every GICS sector to varying degrees, the most in Materials (down 10%), the least in Utilities (down less than 2% the past five days).

The last time the market rebalanced was in early July, the first part of the third quarter of 2018.  Our Sentiment Index dipped below 4.0, a market bottom.  We observed no meaningful rebalancing again in July, or August, or September. Each time the market mean-reverted to 5.0 without turning negative, we warned of compounding imbalances.

Market Sentiment was about 4.0, a bottom, Oct 15, after topping Sep 26. Into expirations today through Friday, we expected a strong surge because all the stuff that was overweight is now underweight (the surge arrived a day early, before VIX expirations).

These cycles tend to shorten as markets break down. We had six bottoms in 2015, the last time the market was negative for the year. This is the third for 2018 after just one in 2017. Aging bull market?

ETFs and Divine Creation and Redemption

There’s a saying: It’s easier to keep the cat in the bag than to get it back in there once you’ve let it out. Nobody is likely to stuff the Exchange Traded Fund (ETF) cat back in the bag.

Because ETFs are miraculous.

The biblical story of creation is that something came from nothing. Same with the Christian concept of redemption – being bought for a price without rendering equal worth in kind.

Today, we’ll share with occupants of the IR chair the divine story of how ETFs work.

Before ETFs were closed-end mutual funds. Closed end funds (CEFs) are publicly traded securities that IPO to raise capital and pursue a business objective (like any business), in this case an investment thesis. Traded units have a price, and the net asset value rises and falls on the success of managers in achieving objectives. The rub with CEFs is that share value can depart from net asset value – just like stocks often separate from intrinsic business worth.

The investment industry, with support from regulators, devised ETFs to magically remedy through Creation and Redemption this fault of nature. ETF kingpin iShares, owned by Blackrock, illustrates here, with a clever floral analogy (thank you Joe Saluzzi at Themis Trading who alerted us to it). You don’t have to buy individual flowers and face market risks because iShares puts them in a bouquet for you. Great idea. (more…)