September 16, 2015

ETF Bubble

“We’re 90% in natural gas and natural-gas liquids,” said the investor-relations officer for a NYSE-listed master-limited partnership at yesterday’s NIRI luncheon in Houston, where I spoke on ETFs. “Yet we’re tracking oil.”

In Michael Lewis’s brilliant The Big Short, a small group of people come to believe mortgages are a bubble because they’ve been extended into derivatives treated as though of equal value and composition to the homes and loans backing the mortgages. No distinction then was being made between good mortgages and bad ones, the same woe afflicting our MLP above through models like ETFs. Thus began the big short – bets that a reckoning was coming.

In the stock market the core asset is stocks of public companies. There is a finite supply, which due to widespread corporate consolidation and share-repurchases isn’t increasing. But indexes that cluster stocks into convenient risk-diffusing groups have proliferated.

At the same time, brokers once carrying shares to mark up and sell to big institutional customers have been forced out by rules, and the intermediaries now, fast traders, often have but 100 shares at a time. Without ready stock, it’s gotten very hard for institutions to buy and sell big positions.

Enter exchange-traded funds. Through ETFs, institutions transfer the risk of finding mass quantities of shares to an arcane behind-the-scenes group of custodian brokers called in ETF lingo “authorized participants.” Think of firms playing this role as running the warehouses.

Here’s how it works. Blackrock creates an ETF tracking an index. The ETF must be comprised of percentages of each of its stocks. Blackrock turns to the warehouse, the Authorized Participant (AP), who gets the components off the shelves and packages vast amounts into what are called creation units. You can’t sell ETF shares back to Blackrock. Only the AP can. For investors, ETFs must be bought or sold on the “secondary market.” That is, just like stocks.

If money buys the ETF instead of the index, wouldn’t it rise faster? Thanks to special ETF rules, no. If investors want the ETF, Blackrock has its AP manufacture more ETF units to meet demand – so supply is theoretically infinite.

ETFs in effect cut out the middle man, the stock market. How? For one, ETFs can substitute cash or securities like options and futures for stocks (and they can hold but a statistical sample of the index).

Suppose investors are buying an underlying stock like XOM, and indexes containing XOM, and ETFs tracking energy and including XOM. The sponsor asks the AP for a lot of XOM and the other components so it can whip up more ETF shares. The AP checks the warehouse, and there is no more XOM. So it substitutes cash and futures of equal value.

Second, this “warehouse” concept reflects how APs, we’re led to believe, seem to have infinite access to shares of stock (which we know is impossible). You can’t find a list of APs but experts say they’re big banks getting special permission from ETF sponsors to act for them.

I have a theory. Often in 13F regulatory filings required by the SEC, holdings for the biggest investors like Blackrock and Vanguard barely change. Positions in 13Fs usually roll up to the parent. Maybe the parent’s subunits buy and sell from each other for indexes and ETFs through the APs. It’s an explanation.

Whatever the truth, ETFs are the biggest success in modern financial history because they make it easy for investors to do something that in reality isn’t: get big exposure without altering the market. Thus, ETFs are a form of credit-extension because they offer investors access to something they otherwise couldn’t buy.

Collateralized debt-obligations did the same for mortgages – turned them into something every investor could own regardless of the number or quality of underlying mortgages.

Bubbles manifest not through valuations but when values stop rising. Let’s theorize that the market stalls for an extended period.  Investors get nervous and sell XOM and the index and the ETF. The futures held in place of XOM are now worthless. To prevent panic, the AP sells assets to cover the loss.

Markets deteriorate further. Panic starts.  The AP is tangled up in swaths of valueless derivatives (just like the CDO market). Then it defaults because its balance-sheet no longer qualifies it to serve as an AP. Bear Stearns and Lehman Brothers were big counterparties that failed. A domino effect ensued as balance sheets laden with empty paper imploded.

Public companies, know what ETFs hold your shares and whether they’re big names (we can help you). Your management teams and Boards should understand ETFs and your company’s exposure to them (and the volume multiplier). Even better, you should be tracking every day what sets price (we can do that for you).

The risk I propose here probably won’t manifest. But in the May 6, 2010 Flash Crash, 70% of halted securities were ETFs. On Aug 24, 2015 when markets nearly imploded, there were 1,000 ETF volatility halts.

We might have an ETF bubble.

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