Lurking Dangers in ETFs during a Stock Market Sell-Off

by The Curmudgeon

Introduction:

U.S. exchange-traded funds (ETFs) have never been more popular. The combined assets of the all U.S. listed ETFs were $1.481 trillion in May 2013 - up over $365B year-over-year, according to the Investment Company Institute. But only recently have serious problems with ETFs become evident and alarming. The CURMUDGEON thinks this is just the tip of the iceberg. This article explains several problems with ETFs that most investors and speculators are not aware of. In particular, one scenario that no one that we know of has described before.

Background:

On Thursday June 20th (1 day after Bernanke’s post-FOMC press conference), ETF prices not only dropped sharply, but the spread between the price of the ETFs and their underlying assets widened dramatically. At the exact time that investors in large numbers attempted to redeem their ETF shares, they had to sell at a significant discount to the actual assets their fund tracked. For example, the share price of the iShares MSCI Emerging Markets ETF fell to a 2.6 % discount to the underlying asset value. On June 21st, GLD fell to a 3.1% discount to the spot gold price [the CURMUDGEON wondered why arbitrageurs didn't buy GLD and sell spot Gold or the near month COMEX futures contract].

The Financial Times reported that Citigroup stopped accepting orders to redeem underlying assets from several ETF issuers, after one trading desk reached its allocated risk limits. State Street contacted ETF participants “to say we were not going to do any cash redemptions today”. But he added that redemptions “in kind” were still taking place.

Citigroup and Sate Street’s temporary suspension of sell orders point to more ominous consequences resulting from the ETF market’s ability to artificially distort the costs of underlying assets. The result is a situation in which the ETF’s relationship to its underlying assets becomes parasitic- like the tail wagging the dog. We think that this could exacerbate any global stock (or bond) market decline and pose a huge danger to the global economy! [This is described in the last section of this post.]

Deja Vu all over again:

Yet this very problem (and others) was predicted in a November 2010 research report from the Kauffman Foundation, which warned of fundamental dangers in the way ETFs were constructed. The report’s authors, Harold Bradley and Robert Litan, stated that ETFs pose systemic risks to the global economy that are similar to those observed during the “flash crash” which occurred in April 2010. They wrote:

“ETFs are radically changing the markets, to the point where they, and not the trading of the underlying securities, are effectively setting the prices of stocks of smaller capitalization companies, or the potential new growth companies of the future. In the process, ETFs that once were an important low-cost way for investors to assemble diversified stock holdings are now undermining the traditional price discovery role of exchanges and, in turn, when combined with the high Sarbanes Oxley compliance costs for small companies are discouraging new companies from wanting to be listed on U.S. exchanges."

In a recent email to Kate Welling, Mr. Bradley wrote: "Implicit in the ETF no-action (SEC) approach is the obligation for market makers to keep the cash (individual securities the ETF attempts to replicate) and ETF markets aligned throughout the day. Discounts should fall outside the no-action rationale."

Worrisome Implications:

Michael Teague wrote in a July 2nd blog post:

"There is no telling what form the reaction from investors would take if the practice of 'temporarily' preventing them from cashing out on underlying assets spreads from Citigroup and State Street spreads to other financial institutions in the event of a more severe sell-off."

"Emerging Market economies, which have seen an influx of investment, thanks to the popularity of Emerging Market ETFs, could take a serious hit if the type of outflow that has been seen over the past two weeks gets any more serious than it already is."

The Financial Times stated that the big investment banks, which are needed to underpin the ETF market, “may no longer be willing to support ETFs in volatile markets.”

Bloomberg reported that many of the less liquid ETFs are seeing increasingly alarming gaps (i.e. discounts) between their market prices and the values of the underlying securities they represent. These ETF discounts weren't supposed to happen: Authorized Participants (AP's are the middlemen between ETF buyer and seller) were to create and destroy ETF units in line with buy/sell volume. But it didn't pass the stress test of large sell orders last month in Emerging Market Equities, Fixed Income and Gold ETFs.

Closing Comments:

Those ETF discounts add insult to injury for the majority of listed ETFs (perhaps over 80%), which typically have huge bid/ask spreads. That results in bad fills on market and stop orders. That' why most hedge funds and managed accounts only use 30 to 100 ETFs for their clients.

But we think there's a huge risk with ETFs that no one is talking about.

During a severe stock market sell-off, discounts on some popular ETFs - like the iShares Russell 2000 Index (IWM)- could widen sufficiently that the underlying stocks would be immediately sold by the middlemen and computerized traders. That could result in new selling of that same ETF (already trading at a discount) by other traders. This selling could be some combination of short sales and long liquidation by institutional and individual investors. In the IWM example, that's 2000 individual stocks under selling pressure caused by a single ETF selling at a discount.

A snow ball type of decline could ensue, reminiscent of the October 19, 1987 crash. At that time, "portfolio insurance" was triggered when stock index futures contracts were sold to "protect" a portfolio of stocks. It didn't work very well then. :-((

Could the same phenomenon occur with ETFs on a sharp market sell-off? We certainly hope not, but there's now a new risk to consider when buying or selling ETFs!

Till next time.....................

The Curmudgeon
ajwdct@sbumail.com

Curmudgeon is a retired investment professional.  He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996.  He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.