Tagged: ETFs

Pricing Everything

As the colors of political persuasion in the USA ripple today, what matters in the equity market is what the money is doing.

We measure Sentiment by company and sector and across the whole market daily. It’s not mass psychology. Rational thought sets a small minority of prices (your board and execs should know, investor-relations professionals, or they will expect you to move mountains when the power at IR fingertips now is demographics – just as in politics).

We’re measuring ebbs and flows of money and the propensity of the machines executing the mass of trades now to lift or lower prices.

When the market is Oversold by our measures, it means Passive money is likely to be underweight relative to its models and benchmarks, and probability increases that machines will lift prices for stocks because relative value – the price now versus sometime in the past 20 days – is attractive. We call it Market Structure Sentiment.

In Oct 2016, before the Presidential election, Market Structure Sentiment saw its worst stretch since Sep-Oct 2014 when the Federal Reserve stopped buying debt, sending the dollar soaring and the energy industry into a bear market.

We at ModernIR thought then that after pervasive monetary intervention the next bear market would be two years out. On the eve of the Presidential election two years ago, and two years out, the Dow 30 traded at Dec 2014 levels.

We figured we’d called it.

We were wrong (the market makes fools of most who propose to prophesy).  Donald Trump won, and stocks surged until October this year.

As I write Nov 6, Market Structure Sentiment has bottomed at 3.5/10.0 on our 10-point scale. In 2016 it bottomed Nov 9, the day of the election (and stocks surged thereafter).

Conclusions?  Maybe rational thought means little.

Consider: The SEC has approved Rule 606(b)(3) (if rules need parentheses it means there are too many – but I digress) for brokers, requiring that they disclose (thank you, alert and longtime reader Walt Schuplak) when they’re paid by venues for trades and trade for their own accounts.

Public companies and investors, why do we need rules requiring brokers to tell us if they’re getting paid for orders or trading ahead? Because they’re doing it. And it’s legal.

If we want to suppress both things, why not outlaw them?

Because the market now depends on both to price everything.

Let me explain. When the SEC exempted Exchange Traded Funds from the Investment Company Act’s requirement that fund-shares be redeemable for underlying assets, they did so because ETFs had an “arbitrage mechanism,” a built-in way for brokers to profit if ETFs deviated from its underpinning index.  (NOTE: If you don’t know how ETFs work, catch the panel at NIRI Chicago next week.)

Those exemptions preceded Regulation National Market System, which capped trading fees – but left open what could be PAID for trades. I bet the SEC never saw this coming.

Rule 606(b)(3) forces brokers to tell customers when they get paid for trades and if they are trading for themselves at the same time.

In ETFs, the two dovetail. Brokers can earn trading incentives legitimately because they’re fueling the SEC-sanctioned arbitrage mechanism, which requires changing prices. Rules let you get paid for it!

Second, since ETFs are created and redeemed by brokers (not Blackrock), much ETF market-making is principal trading – for a broker’s own account.

So ETFs create opportunity for brokers to get paid for setting price, and to put their own trades ahead of customer orders – the things 606(b)(3) wants to highlight.

Now ETFs are the largest investment vehicle in markets, and Fast Trading prices stocks more often than anything else. Suppose you’re the SEC. What would you do?

Let’s put it in mathematical terms. Our analytics show 88% of trading volume is something besides rational investment. We blame rules that focus on price. Whatever the cause, there’s a 12% chance rational thinking is why Sentiment is bottomed at midterms.

I think the SEC knows. Can they fix it? Well, the SEC created it to begin.

For now, public companies, every time you look at stock-price, there’s a 12% chance it’s rational. Does your board know? If not, why not? Boards have fiduciary responsibility.

And investors, are you factoring market structure into your decisions? You’d best do so. Odds favor it.

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?

Electric Market Toothbrush

We were in Portugal and our electric toothbrush went haywire.

It would randomly turn on in the night, and no amount of pressing the button would silence it. We abandoned it in Evora in the shadow of 2,000-year-old Roman aqueducts that still work.

The point isn’t the ephemeral nature of manufactured products (Amazon assured we’d have a replacement waiting, so the modern era works!). But two recent events show how the stock market is built for the short-term – and may run of its own accord.

First, the Wall Street Journal reported Sep 21 that a judge is permitting a class action suit from customers to proceed against TD Ameritrade alleging the big discount broker with 11 million customers breached its “best execution” obligation.

For you investor-relations professionals who’ve heard about the Fee Pilot Program proposed by the SEC, this gets to the heart of it. For you investors, it illustrates how market structure is trumping investment motivation.

Let me explain.  The suit claims TD Ameritrade put its own interest above that of its customers because it routed customer trade-executions to high-speed traders for payment, earning $320 million. TD Ameritrade had net income of about $870 million in 2017 – so selling orders was over 35% of the bottom line.

There’s no law against it, and rules encourage it by forcing trading to occur between the national best bid to buy or offer to sell. Prices constantly change as machines move bids and offers, breaking trades into small pieces to profit on intermediating them.

Retail brokerages sell orders to high-speed firms to avoid these marketplace challenges (of note, the WSJ said Fidelity stopped selling its orders in 2015, an exception in the group). That fast traders paid $320 million for orders suggests they can sell them for more – money that should have gone to the customers rather than the intermediaries.

One could argue spreads are so low that what difference does it make?  What’s a few pennies on a hundred-share order?

The problem is that fees for orders change behavior. High-speed firms aren’t investors. They profit by changing prices. That’s arbitrage, and it becomes both means and end.

What’s the definition of volatility?  Unstable – changing – prices. Rules create economic incentives to change prices. Intraday volatility marketwide is 2.3%, far higher than what the VIX based on implied volatility suggests. Arbitrage is the opposite of long-term investment. Why would we want rules that encourage it?

This is why we support the proposed SEC study that would include eliminating fees in one group (an astute IR guy observed to me in Washington DC last week that every stock should spend time in each of the buckets so there is no discrimination). We don’t want arbitrage pricing the market we all depend on as a gauge of fair value.

Which leads to the second item. The ETFMG Alternative Harvest ETF, a pot fund amusingly tickered “MJ” (last dance with Mary Jane, one more time to kill the pain, sang Tom Petty), made headlines for sharp divergence from its intraday indicative value.

ETFs are required to report net asset value every 15 seconds. Traders can arbitrage – here it comes again – ETF shares as they cross above or below NAV.

(Programming note: I’ll be at the Connecticut/Westchester Chapter Oct 3 talking about the impact of ETFs on markets and your stock, and we’re sponsoring the NIRI Chicago Chapter this Friday the 28th so stop by and say hi!)

The SEC is now proposing to eliminate that requirement so ETFs would price once a day like actual pooled investments such as index mutual funds.  Here’s the kicker: The SEC in first permitting ETFs to trade exempted them from the “redeemable security” mandate in the Investment Company Act of 1940.

That is, all pooled investments must exchange investors’ shares for a proportionate part of the pool of assets when asked. ETFs are exempted from that provision. They are not redeemable. The SEC approved them because creators said the “arbitrage mechanism” would make them in effect redeemable because they would have the same value as an index.

What if the arbitrage incentive diminishes?

To me, the problem today for investors and public companies is the market’s staggering dependency on arbitrage. High-speed traders and Passive money, the latter mostly ETF market-making, are 80% of market volume. The two behaviors at issue in these situations. The math on SPY, the world’s largest ETF, suggests arbitrage is an astonishing 94% of its trading volume when compared to gross share-issuance.

It’s like an electric toothbrush you can’t shut off. What you thought was an instrument designed to serve a purpose can no longer be controlled.  It’s creditable that the SEC is investigating how its rules may be running the toothbrush – and courts could put a spotlight on a market priced by the fastest orders.

We don’t need to go back to Roman aqueducts (though they still work). We can and should recognize that the market has gotten awfully far removed from its intended purpose.

Age of Discovery

Bom Dia!

We returned Monday from Portugal after two fantastic weeks roaming and pedaling this land famed for its explorers. We stood at Cape St. Vincent, once the end of the known world where Vasco da Gama, Ferdinand Magellan and Christopher Columbus sailed off to what many thought was a ride over the edge.

In a sense, the investor-relations and stock-picking professions are at Cape St. Vincent. The market we’ve known, the one driven by business fundamentals, is a spit of rock projecting into a vast sea of unknown currents.  We are explorers on a forbidding shore.

Henry the Navigator, father of the Age of Discovery, challenged fear, superstition and entrenched beliefs to create the Harvard of sailing schools on the barren shoals of Sagres, a stone’s throw south of Cape St. Vincent. From it went intrepid adventurers who by sailing what proved to be a globe laid the cornerstones of today’s flattened earth that’s interconnected economically and culturally.

Speaking of conquering the unknown, I’m paneling for the NIRI Virtual chapter at noon ET today on the impact of Exchange Traded Funds, then tomorrow addressing the Capital Area NIRI group on how ETFs drive the market.

It’s what the money is doing. If as IR professionals we’re to fulfill our responsibilities to inform our boards about important facets of equity valuation, we have to know these things as explorers knew the sextant.

By the same token, investors, if you know only how stocks should be valued bottom-up but not how the market transforms stocks into products and data priced by arbitrage, then you’ll fail to beat the benchmark.  Market Structure is as essential to navigation as was knowing currents and stars and weather patterns for yesteryear’s seafarers.

How do we at ModernIR know we’ve got the right navigational tools for today’s market?  Vasco da Gama combined knowledge and forecasts learned at the School of Navigation to find a passage by sea to India.

We combine knowledge of market rules and the behavior of money with software and mathematical models that project outcomes – passages.  If our knowledge is correct, our sextant will mark a course.

Our models are roughly 93% accurate in forecasting short-term prices across the entire market – a startling achievement. For comparative purposes, moving averages have no measurable statistical capacity to forecast prices, and variances between them and actual prices are factors larger than that in our models. Why use tools that don’t tell you where you’re going?

Ownership-change is a tiny fraction of trading volume. What does it tell you about how your price is set?  Nothing. By contrast, patterns of behavioral change are as stark as waves in Cascais – or the world’s biggest surfers’ waves off Nazare.  We see waves of sector rotation, short-term turns in the market – just like weather patterns.

We’re in an age of discovery. Some will cling to a barren spit of land, doing what they’ve always done. The rest will set a new course to a future of clarity about how stocks are priced and valued and how money behaves.  Which group will you be in?

Hope to see you at a NIRI chapter meeting soon!  And ask us how we can help you navigate the coming earnings season with better tools.

Borrowed Time

“If a stock trades 500,000 shares daily,” said panelist Mark Flannery from hedge fund Point72 last Thursday on my market-structure panel, “and you’ve got 200,000 to buy or sell, you’d think ‘well that should work.’ It won’t. Those 500,000 shares aren’t all real.”

If you weren’t in Austin last week, you missed a great NIRI Southwest conference.  Mr. Flannery and IEX’s John Longobardi were talking about how the market works today.  Because a stock trades 500,000 shares doesn’t mean 500,000 shares of real buying and selling occur.  Some of it – probably 43% – is borrowed.

Borrowing leads to inflation in stocks as it does in economies.  When consumers borrow money to buy everything, economies reflect unrealistic economic wherewithal. Supply and demand are supposed to set prices but when demand is powered by borrowing, prices inevitably rise to unsustainable levels.  It’s an economic fact.

All borrowing is not bad. Borrowing money against assets permits one to spend and invest simultaneously.  But borrowing is the root of crises so watching it is wise.

Short interest – stock borrowed and sold and not yet covered and returned to owners as a percentage of total shares outstanding – isn’t unseemly. But it’s not a predictive indicator, nor does it describe risk. The great majority of shares don’t trade, yet what sets price is whoever buys or sells.

It’s far better to track shares borrowed as a percentage of total traded shares, as we described last week. It’s currently 43%, down one percentage point, or about 2.3%, as stocks have zoomed in latter August.

But almost 30% of stocks (excluding ETFs, routinely higher and by math on a handful of big ones averaging close to 60%) have short volume of 50% or more, meaning half of what appears to be buying and selling is coming from something that’s been borrowed and sold.

In an up market, that’s not a problem. A high degree of short-term borrowing, much of it from high-speed firms fostering that illusory 500,000 shares we discussed on the panel, means lots of intraday price-movement but a way in which short-term borrowing, and covering, and borrowing, and covering (wash, rinse, repeat), may propel a bull market.

In the Wall Street Journal Aug 25, Alex Osipovich wrote about how Goldman Sachs and other banks are trying to get a piece of the trading day’s biggest event: The closing auction (the article quotes one of the great market-structure experts, Mehmet Kinak from T Rowe Price). Let’s dovetail it with pervasive short-term borrowing.

We’ve mapped sector shorting versus sector ETF shorting, and the figures inversely correlate, suggesting stocks are borrowed as collateral to create ETFs, and ETFs are borrowed and returned to ETF sponsors for stocks.

A handful of big banks like Goldman Sachs are primary market-makers, called Authorized Participants (as opposed to secondary market-makers trading ETFs), which create and redeem ETF shares by moving stock collateral back and forth.

The banks give those using their versions of closing auctions the guaranteed closing price from the exchanges.  But it’s probably a great time to cover short-term ETF-related borrowings because trades will occur at an average price in effect.

The confluence of offsetting economic incentives (selling, covering borrowings) contribute to a stable, rising market. In the past week average intraday volatility dropped to 1.9% from a 200-day average of 2.5% at the same time shorting declined – anecdotal proof of the point.

What’s the flip side?  As with all borrowing, the bill hurts when growth stalls. When the market tips over at some future inevitable point, shorting will meet shorting. It happened in January 2016 when shorting reached 52% of total volume. In February this year during the correction it was 46%. Before the November election, short volume was 49%.

The point for both investors and public companies is that you can’t look at trading volume for a given stock and conclude that it’s equal and offsetting buying and selling. I guarantee you it’s not.

You don’t have to worry about it, but imbalances, however they may occur, become a much bigger deal in markets dependent on largescale short-term borrowing. It’s another market-structure lesson.

Block Monopoly

This year’s rare midweek July 4 prompted a pause for the Market Structure Map to honor our Republic built on limited government and unbounded individual liberty. Long may it live.

Returning to our market narrative: Did you know that 100% of Exchange Traded Fund creations and redemptions occur in block trades?

If you’ve got 48 minutes and a desire to understand ETFs, catch my podcast (you can get our ETF White Paper too) with IR Magazine’s Jeff Cossette.

In stocks, according to publicly reported data, three-tenths of one percent (0.3%) of NYSE trades are blocks (meaning 99.7% are non-block).  The Nasdaq compiles data differently but my back-of-the-envelope math off known data says blocks are about the same there – a rounding error of all trades.

Blocks have shrunk due to market regulation. Rules say stock trades must meet at a single national price between the best bid to buy and offer to sell.  That price relentlessly changes, especially for the biggest thousand stocks comprising 95% of volume and market cap (north of $2.5 billion to make the cut) so the amount of shares available at the best price is most times tiny.

We track the data.  At July 9, the average Russell 1000 stock traded 13,300 times per day in 160-share increments.  If you buy and sell shares 200 at a time like high-speed traders or algorithmic routers that dissolve and spray orders like crop-dusters, it’s great.

But if you buy cheese by the wheel, so to speak, getting a slice at a time means you’re not in the cheese-wheel buying business but instead in the order-hiding business. Get it? You must trick everybody into thinking you want a slice, not a wheel.

The cause? Market structure. Regulation National Market System, the regime governing stock trades, says one exchange must send to another any trade for which a better price exists there (so big exchanges pay traders to set price. IEX, the newest, doesn’t).

Put simply, exchanges are forced by rules to share prices. Exchanges cannot give preference to any customer over another.

ETFs get different rules. Shares are only created in blocks, and only traded between ETF creators and their only customers, called Authorized Participants.

I’m not making this up. When Blackrock wants more ETF shares, they create them in blocks only.  From Blackrock’s IVV S&P 500 ETF prospectus: Only an Authorized Participant may engage in creation or redemption transactions directly with the Fund. The Fund has a limited number of institutions that may act as Authorized Participants on an agency basis (i.e., on behalf of other market participants).

Why can ETFs offer preference when it’s against the law for exchanges? Fair question. There is no stated answer. The unstated one is that nobody would make markets in ETFs if a handful of firms didn’t have an unassailable competitive advantage, a sure chance to make money (why ETF fees are so low).

Again from the IVV prospectus:

Prior to trading in the secondary market, shares of the Fund are “created” at NAV by market makers, large investors and institutions only in block-size Creation Units of 50,000 shares or multiples thereof.

Each “creator” or authorized participant (an “Authorized Participant”) has entered into an agreement with the Fund’s distributor, BlackRock Investments, LLC (the “Distributor”), an affiliate of BFA. A creation transaction, which is subject to acceptance by the Distributor and the Fund, generally takes place when an Authorized Participant deposits into the Fund a designated portfolio of securities (including any portion of such securities for which cash may be substituted) and a specified amount of cash approximating the holdings of the Fund in exchange for a specified number of Creation Units.

And down a bit further (emphasis in all cases mine):

Only an Authorized Participant may create or redeem Creation Units with the Fund. Authorized Participants may create or redeem Creation Units for their own accounts or for customers, including, without limitation, affiliates of the Fund.

Did you catch that last bit? The creator of ETF shares – only in blocks, off the secondary market (which means not in the stock market) – may create units for itself, for its customers, or even for the Fund wanting ETF shares (here, Blackrock).

And the shares are not created at the best national bid to buy or offer to sell but at NAV – Net Asset Value.

Translating to English: ETF shares are created between two cloistered parties with no competition, off the market, in blocks, at a set price – and then sold to somebody else who will have to compete with others and can only trade at the best national price, which continually changes in the stock market, where no one gets preference and prices are incredibly unstable.

It’s a monopoly.

Two questions:  Why do regulators think this is okay? The SEC issued exemptive orders to the 1940 Investment Company Act (can the SEC override Congress?) permitting it.

We wrote about the enormous size of ETF creations and redemptions. Which leads to Question #2: Why wouldn’t this process become an end unto itself, displacing fundamental investment?

The Actionable Hoax

What’s actionable?

It’s a buzzword of business and the investor-relations profession. And, yes, my title violates a rule of grammar because you can’t tell if the topic is a hoax about actionability or if a hoax out there has proved actionable.

We’ll answer using the market. Like this: Trade-war threats are wrecking markets!  Right?

Wrong.  Pundits tying moves in the market to headlines don’t understand market structure. Suppose you’re getting “actionable” information from pundits who don’t know how the market works. Are the recommended actions reliable?

While you ponder that, consider this: If trade concerns for tech stocks caused the correction in February, why did the Nasdaq hit an all-time high June 20? Did the same money that rejected the market back then on trade fears three months later without resolution to those concerns pay more?

You can say, “No, they were sellers.” Okay, so who bought?

Market experts are often offering actionable intelligence based on outdated ideas. But they have a duty to understand how the market works and what the money is doing.

In fact, these two pillars – how the market works, what the money is doing – should be the bedrock for understanding markets.

What’s the money doing?  It’s not choosing to be directed by rational thought. We know  because a vast sea of data on fund flows tells us so. If we as investors or investor-relations practitioners continue doing what we did before fund flows surged to passive money, who is the bigger fool?

Exchange Traded Funds (ETFs) are driving 50% of market volume now. They are passive vehicles. But they uniquely among investment products permit ETF creators like Blackrock and Vanguard a step-up in tax basis through creation and redemption.

How? Say NFLX is up 100% in three months, imputing tax costs to ETF shares. Creators of ETFs collateralized by NFLX shares will put it in redemption baskets exchanged to brokers for returned ETF shares.  (NOTE: If you don’t know how ETFs work, ask us for our ETF whitepaper.)  NFLX then plunges as brokers sell and short it.

Five days later, the ETF creator can bring NFLX back now in a creation basket of new ETF shares that it will issue only in exchange for NFLX – laundered of tax consequences.

Apply this to the Technology sector (or the whole market for that matter).  We just had Russell index rebalances, and Technology is a big part of market cap.  S&P indices rebalanced June 22 and Technology is over 25% of the S&P 500 now.

This week is quarter-end window-dressing. ETFs are trying to bleed taxes off runups in Tech stocks.  We could see it coming in Sentiment by June 14, when it topped, signaling downside, and when behavioral volatility indicated big price-swings. Data say we have another rough day coming this week.

Headlines may help prioritize what gets tax-washed, so to speak, but the motivation is not investment. It’s aiming at picking gains and packing off tax consequences.

The market is driven far more by these factors than rational thought, which we know by studying the data. ETF creations and redemptions are hundreds of billions of dollars monthly. Inflows and outflows from buy-and-hold funds are nonexistent by comparison.

Ergo, it can’t be rational thought driving the market no matter the talking heads declaiming trade threats.

It’s what lawyers call a “fact pattern.” ETFs dominate passive investment, drive 50% of market volume, depend on tax efficiency, which process is an arbitrage trade that involves a continual shift of hundreds of billions monthly in underlying assets, and a corresponding continual shift in collateralizing assets called stocks – with market-makers profiting, and ETF creators profiting – without regard to market direction.

It’s poor fodder for a 24-hour news cycle. But it explains market behavior. Moves have become more pronounced because money stopped pouring into US equities via ETFs this year. Volatility exploded because getting tax efficiency got harder.

Which brings us to the “actionable” hoax. The word “actionable” says consumers of products or services are fixated on a prompt, a push, an imprimatur.

Fine. But flinging the word around causes investors and IR professionals to miss what matters more, and first.  Investors and public companies should be asking: “How does this service or that tool help me understand what the money behind stocks is doing?”

Ask your service provider to explain how your stock trades. Then ask us to explain it.

If they don’t match, ask why. The beginning point of correct action is an understanding of what you can and cannot control, and how the environment in which you operate works.

Take the weather. We can’t control it. But it determines the viability of our actions. The same applies to understanding market structure. It determines the viability of actions.

If you want to learn market structure, ask us how, IR professionals and investors.  It’s the starting point. What you think is actionable may be a hoax. Compare how the market works to what you’re doing. Do they match? If not, change your actions. We’ll help you.

Liar’s Poker

We’re back! We recommend Barbados but we didn’t see Rihanna.

We also endorse floating around the Grenadines on a big catamaran turning brown and losing track of time. We had rum off the shore of Petit Tabac where Elizabeth set Captain Jack Sparrow’s rum store afire.

Meanwhile, back in reality the dollar rose and interest rates fell, and Italy slouched into confusion, and Argentina dodged a currency crisis for now, and Venezuela…well, Venezuela is like that rum fire Elizabeth set in Pirates of the Caribbean.

I at last read Liar’s Poker, Michael Lewis’s first book (and also Varina, by Charles Frazier, a lyrical novel that sighs like wind through live oaks, imagining life in the eyes of Mrs. Jefferson Davis).

With the boat and the sea taking us far from cell towers, we hit the power buttons and blinked out and I with cold Carib at hand, the beer of the Caribbean, sailed through Mr. Lewis’s time at Salomon Brothers in the bond frenzy of the 1980s.

Mr. Lewis explains how a Federal Reserve decision in Oct 1979 by then chairman Paul Volcker to fix the supply of money and float interest rates stuffed the turkey for Salomon. Overnight, bonds moved from conservative investments held to produce income, to speculative instruments driven by bets on big swings in prices.

For Salomon, the money was in toll-taking. They bought bonds from those selling at incorrect prices and sold them to others willing to buy at incorrect prices. They kept a middleman’s sliver. Do it enough and you’re rich. If you’ve not read the book, do so. There’s verisimilitude for today’s stock market.

The Fed abandoned floating interest rates in 1982, reverting to influencing the Fed Funds rate as it still does today (setting interest rates and flexing the money supply). But speculation on price-changes is now rampant, having spread into everything from currencies to equities.

It matters because anytime supply and demand are not the principal price-setters, a market cannot be depended on to offer reliable fundamental signals. The US stock market thanks to Exchange Traded Funds now may be the most arbitraged in human history.

You might be thinking, Tim, did time on the boat not dump your ETF cache? Also, why do I care?

I return to the ETF theme because investors and public companies continue to assign the market disproportionately fundamental interpretations. You should care because Salomon is gone, swept away on the tides of history because it didn’t keep up. Are we keeping up?

The motivation behind the two parties to every ETF creation and redemption – and neither one of them is you – is capturing a price-spread.  It’s not investment.  Yes, you as an investor may buy ETFs as an investment. But the parties creating and redeeming them are doing so to make money on how prices change.

That’s arbitrage. And what determines the value of investments isn’t who holds them but who buys or sells them (this is the flaw in thinking your stock reflects value assigned by buy-and-hold investors).

In a way, it’s what Mr. Lewis describes in Liar’s Poker, where Salomon merchandised the market’s ignorance about what priced bonds.

How many people understand that ETFs are not managing the money they spent buying ETF shares? ETFs have everyone believing they’re buying a pooled investment when it’s not. Whose fault is it?  Don’t we all bear a responsibility to understand what we’re buying, or what’s affecting the value of our traded shares, companies?

ETFs are the dominant stock financial vehicle of this very long bull market. What matters to those behind trillions of dollars of ETF share-creations and redemptions isn’t the objective of the ETF – but how the prices of ETFs change versus the underlying assets used to collateralize their creation.

Thus a fundamental tremor like trouble in Italy becomes volcanic, spewing molten lava all over stocks. The true driver is arbitrage. Bets. Liar’s Poker. Let’s not be fooled again.

BEST OF: Green and Purple

EDITORIAL NOTE:  We are on a big catamaran with Painkillers in hand watching the sun dissolve into an aqua Grenadine sea. So while we all float on, here’s Part Two of our return to the past to learn today’s lessons. The piece below originally ran Mar 7, 2018. If we’re going to understand today’s market, we must wrap our minds around the vastness of the ETF Effect:  

I can’t find a team (men’s or women’s) headed to March Madness, the annual collegiate sports fete in the USA, wearing green and purple. But the market’s awash in them.

Don’t you mean red and green, Tim?  Buy and selling?

No, green and purple.  See this image?  Green and purple are Passive Investment and Risk Management, a combination revealing how arbitrage in Exchange Traded Funds (ETFs) is taking over the stock market.

In the first circle, green and purple coincide with short covering (lower bar graph) and a surge in price.  In the second, green and purple again, shorting up, price falls.  It’s an anonymous stock exemplar but we see these patterns everywhere.

Monday, a friend sent me a note: “First thing I heard today when I got in the car to go to work and turned on the news is ‘Dow is down on fears of Trump tariff.’  Now I see the market is up 400 points. Should it say: ‘Markets up on Trump tariff?’”

Some pundits, coughing in advance, said it was reduced fears of tariffs on Canada and Mexico. It may be the green and purple gang and not rational thought at all.

I’ve written before about the “arbitrage mechanism” for ETFs.  Google “ETF arbitrage mechanism.” It’s presented as a good thing – the way ETFs can closely track an index.

Yet apart from ETFs, regulators, congresspersons, pundits, investors, all rail at “the arbitragers” for distorting prices and manipulating markets.  Isn’t it cognitively dissonant to say it’s good for ETFs but bad elsewhere?

If we don’t know what’s pricing the market because a pervasive “arbitrage mechanism” – green and purple going long and short – trumps Trump tariffs or any other fundamental consideration, the market cannot serve as a reliable barometer for corporate effort or economic activity.  I’m surprised it’s not troubling to more.

For every trade executed in the stock market in December, 19 were cancelled before matching according to Midas data from the SEC.  Of those that completed, 30% were odd lots – less than 100 shares (no wonder average trade size is about 180 shares).

Trade-cancellations in ETFs run about four times higher than in stocks, near 80-to-1, Midas shows. If trading motivation is changing the price, cancellations will run high.  Investors don’t do it. Profiting on price-differences is arbitrage. Only 5% of US stock orders execute, suggesting a lot of arbitrage. It’s rampant in ETFs. Green and purple.

Here’s what I think. Brokers trade collateral like stocks and cash at a fixed, net-asset-value to ETF sponsors tax-free for ETF shares. They cover borrowed stock-shares, bet long in futures and options on the indexes and components and sell ETF shares to investors.

When the group or index or sector or market-measure has appreciated to the point the ETF sponsor will incur taxes on low-basis stocks in the collateral the brokers provided, the brokers short those stocks and the options and futures and buy the ETF shares and return them to receive the collateral back in exchange.

Headlines may create entries and exits. This process repeats relentlessly, prompting investors and pundits and companies to draw widespread false correlations between market behavior and fundamental or economic factors.

It’s a genius way for brokers, traders and fund sponsors to make money. One could say we all benefit by extension. To a point, yes. So long as more money comes into the market than leaves it, stocks rise.

Volatility mounts on over-correction, where the arbitragers cover at the wrong time, short at the wrong time or exchange collateral for ETF shares in ill-timed ways, leaving puzzled people watching the tape.

Upon reflection, I guess it’s a good thing no team is wearing green and purple. The rest of us would do well to get as good at pattern-recognition as we are at PE ratios, because the patterns are setting prices. Watch the green and purple.