Tagged: heartbeat trades

Beating Hearts

As the Dow Jones Industrials surged over 300 points on April Fools Day, the behavior driving it was Exchange Traded Funds, not rational thought reacting to economic data.

But aren’t ETFs manifestations of rational thought? Investors see, say, good Chinese manufacturing data, and pump money into them?

I’m not talking about fund flows.  I’ll explain.

CNBC reported that investors withdrew about $6 billion from stock funds during the first quarter’s epic equity rally. How can stocks soar when money is leaving?

We wrote Mar 20 that tallying fund-flow data in Q4 2018 when the market fell about 20% showed net static conditions. That is, $370 billion left stock-picking portfolios and the same amount shifted to passive funds. If no money left, why did stocks crater?

We should ask why fund flows don’t match market-performance. It seems like everyone is running around with fingers in ears going, “La la la la!” amid these uncomfortable realities.

Bloomberg wrote a wildly compelling piece on “heartbeat trades” Mar 29, taking a cue from FactSet’s Elisabeth Kashner, who first wrote about this ETF phenomenon in late 2017.

The gist is that ETFs somehow get short-term cash or stocks to finance creating ETF shares, which go to the provider of the loan as collateral, and then days later the ETF sponsor provides the bank with high capital-gains stocks equal to the value of the ETF shares, which it receives back.

Follow that?  Money is traded for ETF shares, which in turn are traded for stocks.

(Note: We should also wonder where those stocks came from if the market doesn’t suddenly take a selling hit afterward. Were they borrowed to start?)

The result of this trade is that taxes associated with the stocks are washed out of the ETF portfolio, ostensibly benefiting ETF investors.

Except ETF investors don’t own a share of pooled assets carrying tax liabilities. ETFs are not backed by any assets. The assets moving back and forth between, say, Blackrock and Goldman Sachs in these heartbeat trades belong to Blackrock, not to investors.

So Blackrock gets a tax benefit.

If you as an investor sell appreciated ETF shares, you owe taxes. That is, if you bought ETFs for $20 per share and they go to $30, and you sell them, you have $10 of gains and you’ll owe either ordinary-income or capital-gains taxes.

Not Blackrock et al.  They don’t own ETF shares.  They own collateral. Washed of taxes through processes such as what Bloomberg describes.

Bloomberg acknowledges that the same event – washing capital gains – occurs through the process of creating and redeeming ETF shares in ordinary course. Vanguard says in its ETF FAQs: “Vanguard ETFs can also use in-kind redemptions to remove stocks that have greatly increased in value (which trigger large capital gains) from their holdings.”

That by the way can hit a stock, undermining great fundamentals.

Creations and redemptions are huge. We had an estimated $1 trillion of ETF “gross issuance,” it’s called, in the time ordinary investors yanked $6 billion from stocks.

Might that $1 trillion have SOMETHING to do with how the stock market has behaved?  Read anything about it?

I’ll give you an example of the impact: the April Fools Day’s stock tirade. Brokers knew ETFs were undercollateralized. That is, if ETFs are supposed to, say, hold 500 S&P components in proportion as collateral, the rate of increase of markets in Q1 has meant they’re sampling only – using a handful of the same liquid stocks repeatedly to create and redeem ETF shares.

But they have to square books sometime. Usually month-ends, quarter-ends.

Fast Traders tipped us to it last week by buying and covering shorts.  So the market surged not on investors buying economic news but on ETF bookkeeping, in effect.

What has not happened yet is washing out capital gains. We saw smatterings only at March options-expirations. That shoe awaits, and ETF horizons in the wholesale market where shares are created and redeemed – again, $1 trillion in Q1 2019 – are fleeting.

These facts – not suppositions – matter because financial punditry is describing the market in fundamental terms when it’s being driven by leviathan tax-avoidance and arbitrage around a multi-trillion-dollar ETF creation-redemption process.

For public companies and investors, that means it’s nearly impossible to arrive at reliably fundamental expectations for stocks.