November 29, 2017

Prospectively Passive

In the past week as stocks jetpacked higher, Passive Investment was 36% of trading volume. The data counter a message Passive managers like Blackrock are propagating: We don’t trade, we just follow stock-pickers.

That’s not just untrue. It contradicts basic facts.

Let me explain using IVV, Blackrock’s S&P 500 Exchange Traded Fund (ETF). The prospectus intimates Blackrock pays no licensing fees to index creator S&P Dow Jones. State Street’s competing SPY pays 0.0303% of assets.

That difference alone gives Blackrock, which charges just 4 basis points, a 50% cost edge over SPY. But why no licensing charge? Because IVV claims to track “an index of large capitalization stocks” replicating performance in the S&P 500 (which is over 82% of market cap), but without becoming the S&P 500.

Blackrock says it “uses a representative sampling indexing strategy…that collectively has an investment profile similar to that of the Underlying Index.”

Similar but not the same. Clever.

The IVV prospectus says it intends to generally invest 90% of assets in a representative sample of the index it aims to track (the S&P 500).

The remaining 10% goes to “certain futures, options and swap contracts, cash and cash equivalents, including shares of money market funds advised by (Blackrock), as well as in securities not included in the Underlying Index, but which (Blackrock) believes will help the Fund track the Underlying Index.”

I’m not picking on Blackrock. but I don’t think people understand what’s going on. Blackrock is in effect acting like a hedge fund while claiming it sits on stocks and doesn’t turn them over. It’s leveraging its asset base and plying every advantage the rules offer.

The prospectus says it may loan a third of assets, plus any collateral it receives, and it uses “certain futures, options and swap contracts.” Blackrock and its ilk have exploded share-borrowing to more than 40% of all trading volume now. Lending produces profits.

The second layer to peel off this passive onion is “Authorized Participants.”  Both Blackrock and competitor State Street claim they sell infrequently, 5% and 4% respectively.

But it’s sleight of hand. In geopolitics Iran claims it’s not meddling. But it backs Hezbollah, Hamas and others, which actively meddle. Proxies.

IVV fluctuates over 9% every month, tallying daily highs and lows, implying tracking the underlying requires turnover exceeding 100%. If the fund buys and sells only 5% of the time, how could it fulfill its regulatory requirement?

There’s an answer. ETFs farm out index-tracking to proxies.  Blackrock’s Hezbollah – come on, have a sense of humor – is its Authorized Participants (which I’m not calling terrorists).

Every ETF prospectus will have a segment like this: “Only certain institutional investors (typically market makers or other broker-dealers) are permitted to purchase or redeem Units directly with the Trust, and they may do so only in large blocks of 50,000 Units known as ‘Creation Units.’”

Translation: ETFs permit big funds like Blackrock to transfer tracking responsibility to “certain institutional investors” that can front-run inflows and outflows and which perform rebalancing to track underlying measures.

Don’t see the problem? I’ll spell it out. Blackrock tells the public it doesn’t buy or sell much, yet 100% of assets are turning over through a handful of privileged parties who know if there are fund buyers and sellers and can always bet correctly.

With markets continually rising, everybody wins including the rest of us excluded from this club, because the market has only risen for nine years.

But ETFs with statistical samples of broad measures will have two flaws when the market turns.  First, they’ll lack sufficient assets to cover selling when stocks devalue because they dabble, leaving rebalancing to parties wanting to profit on movement rather than through investment.

Second, Authorized Participants will get early directional reads, jumping ahead of you.

Lesson? Don’t believe it when you hear Blackrock claiming to follow Active money. Read the prospectus. They’ve got an edge. It’s helping us all right now. But beware passive dominance. It’ll matter when stocks at some point slide – so be early.

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