January 24, 2018

Arbitrage Mechanism

Arbitrage Mechanism would be a great name for a rock band.

Of course, when bands are named for market terms – Call Option, Factor Model, Shiller PE – the bull market may be ending (let me know if your kid’s garage band is called Flash Crash).

The arbitrage mechanism we’re talking about today is the key to how the most popular investment vehicle of the modern era works. Not bitcoin.  Exchange Traded Funds (ETFs).

Arbitrage means “taking advantage of differing prices for the same asset.” Arbitrage isn’t evil. It’s an opportunity. ETFs are not evil any more than derivatives of any kind including mortgage-backed securities are evil.

But we should know how things work. Why is an arbitrage mechanism essential to ETFs? It’s not obtuse to ask the question.

ETF sponsors say the arbitrage mechanism permits ETFs to price throughout the day instead of once as with mutual funds, and it keeps ETF shares near the net asset value (NAV) of the ETF, in contrast to closed-end funds, where NAV and share-price can veer.

That sounds good. Until you reflect on it.  Why would it be helpful for something other than actual investor interest to set price?

As you ponder, here’s how ETF shares are born. Big brokers called Authorized Participants (APs) exchange securities with an ETF sponsor like Blackrock for ETF shares, which they can then sell to the public. The Investment Company Institute says (page 8 here):

APs play a key role in the primary market for ETF shares because they are the only investors allowed to transact directly with the fund. APs generally do not receive compensation from an ETF or its sponsor and have no legal obligation to create or redeem the ETF’s shares.

APs typically derive their compensation from commissions and fees that clients (such as registered investment advisers and various liquidity providers, including market makers, hedge funds, and proprietary trading firms) pay for creating and redeeming ETF shares on their behalf and from any profits the AP earns while engaging in arbitrage between the ETF’s NAV and its market price.

On one hand it’s ingenious. ETFs trade away the risk of buying and selling real assets to third parties (the APs). Like magic, they then can beat stock pickers, who still must buy or sell stocks in the real world.

On the other, it’s rigged.  Select friends of Blackrock get inside information on ETF demand, which they can share with customers like hedge funds and prop traders for a chance to profit, in exchange for a commission.

Wait, isn’t that what gets you thrown in jail for insider trading? So why is it okay for passive money but not active money?  Is that a level playing field for investors seeking great companies – and the companies courting them?

I want to know why journalists and regulators are mute about this disparity sitting like a naked emperor in the room.

Because it’s working, that’s why. So why worry?

Understand this: ETFs are not buying and selling your shares in the open market, creating demand and supply. They are trading ETF shares to APs for a basket of assets of equal value, thus avoiding transaction and tax costs.

Suppose these assets handed back and forth to facilitate the creation of ETF shares are not unique but the same assets used other places.

When real buying or selling occurs, assets are volatile. They rise, and fall.  Right now assets are only rising.  That alone should tell us that money is leveraged to the underlying assets – and ETFs provide the avenue.

The capacity to understand supply and demand has always supported investment decisions. Without that information, bad companies are rewarded like good companies. And who’s ultimately accountable for market risk? You and me. Investors, public companies. We can’t rely on someone else, such as regulators.

Bad Company is a good name for a rock band.  So is Good Company. We want to be in good company, in a good market. Investment built around an “arbitrage mechanism” should make us seek answers. Smart people always ask why.

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