October 7, 2015

The Replicator

In the television and cinematic series Star Trek, the Replicator creates stuff.  Captain Jean-Luc Picard would instruct it to dispense “tea. Earl Grey. Hot.” This YouTube montage is homage.

Speaking of creating stuff, stocks lately saw the longest 2015 rally in step with the weakest jobs report. It came on derivatives, our data show. The OMC song “How Bizarre” says if you want to know the rest, hey, buy the rights. In stocks, the rights to things rather than the things themselves is what drove them. Traders bought rights.

That means somebody else must buy the stocks.  Exercise the right to buy with a call option and the counterparty – we track counterparties – must fulfill it with shares. One risk for markets is that dealers don’t hold supplies of shares, what’s called inventory.

Why? Rules now discourage banks from carrying risk assets like stocks and require instead owning Tier One capital like sovereign debt (how the product of overspending is safer than the rights to profits is unclear) and so banks have stopped making markets in a majority of stocks. Thus, when derivatives are used they must buy, and stocks soar.

The mortgage crisis I hope taught us to watch how markets work. Mortgages were replicated through derivatives as demand for returns on purchased and appreciating homes outstripped underlying supply. When mortgages stopped increasing and houses started to fall in value, mortgage derivatives imploded.

That risk resides now in exchange-traded funds. ETFs often sample rather than replicate indexes. For instance, yesterday a swath of American Depositary Receipts (ADRs) surged because money rushed into an ETF tracking an MSCI global index that excludes US stocks. The index has nearly 1,850 components but the ETF just over 400, or about 21% of the index’s holdings.

What, you say? The ETF doesn’t own all the stocks? Right. There are two kinds of ETFs:  Physical and synthetic.  The former either own shares or sample them, and the latter rely on derivatives to represent the value of stocks. ETFs track indexes four ways:

Full replication. The ETF buys all the stocks in the underlying index, matching comparative weighting. But it may substitute cash for some or all of the stocks.

Sampling. When the tracking index is large (as in our example above) or if the stocks are not available in sufficient quantity, an ETF may construct a representative sample of the index and own only those stocks.

Optimization. Where sampling focuses on picking stocks reflecting the index’s purpose, optimization is a quantitative approach that uses mathematical models to construct correlation in a set of securities that trade like the index whether they reflect industry characteristics or not.

Swap-replication. ETFs pay counterparties for rights to the economic value of underlying indices. No assets actually trade hands.  This is what synthetic ETFs like Direxion and Proshares use (along with futures and options).

It’s worth noting that the great majority of bond ETFs use sampling because fixed-income issues are so vast and illiquid that full replication is a physical impossibility.

Back to equities, as with all derivatives from collateralized debt obligations to floating-rate currencies, problems don’t manifest until the underlying assets stop increasing in value. Those are your shares. The broad market has generally ceased rising and we’ve had a raft of problems in ETFs.

We don’t need to panic. But ETFs are the modern-era mortgage-backed securities. They were designed to make it convenient for everyone to infinitely own a finite asset class: Stocks. That is impossible, and so, sure enough, ETFs are substituting rights for assets.

It didn’t impact us in the IR profession so long as stocks were up. Whether your shares were in an ETF or not, you benefited from the implied demand in the explosion of ETF assets. When ETFs substitute cash, the resulting rise in your share-price isn’t real.

Do you understand? The dollars didn’t buy shares.  And if ETFs are sampling indexes rather than buying them in full, radical volatility can develop between issues held and excluded.

But there’s a bigger risk. As with mortgage-backed securities, ETFs are a multiplier for underlying assets. ETFs that hold stocks don’t trade them per se. Shares of ETFs trade as a promise against its assets. And ETFs lend securities.

ETFs primarily track indexes. You can’t have one without the other. If ETFs investors leave and index investors leave and both stop lending shares to brokers for intermediaries like high-frequency traders, the structure of the market will fundamentally change.

The Fed’s view notwithstanding, markets can and must both rise and fall, and markets dependent on derivatives fall harder. It’s a lesson of history. If we in the IR profession were responsible for the widget market, we’d continually study widget-market form, function, risk and opportunity.

Investor-relations is the equity product manager. We’d better watch the equity-market replicator (and clients, we do, every day).

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