Last Updated: 20 May 2021
Kauffman’s newest report throws ETFs under the bus. Too bad it’s wrong.
Yesterday’s report from Harold Bradley and Robert E. Litan of the Kauffman Foundation aimed to rock the indexing world, shatter the foundations of the industry and give ETF investors the heebie-jeebies. Even though it’s wrong, it could succeed.
The core argument of the report’s 84 pages, available from Kauffman’s site, is that exchange-traded funds have fundamentally altered the markets for the worse. It cites ETFs as a threat to market stability, negatively affecting stock prices through their structure and mechanics. It says ETFs are shrouded in a fog of mystery and in desperate need of further transparency. And it says that the rise of index trading has destroyed the prospect of IPOs.
All of this is wrong. It’s the ghost story investors might tell themselves around a campfire: an entertaining work of fiction.
It might be helpful to take the key assertions from Bradley and Litan’s report and shine a light on them.
- ETFs pose serious threats to market stability in the future.
That’s a serious statement. Bradley and Litan’s report suggest that, in a high-volatility situation, ETFs will have liabilities they can’t fulfill. The worry is that investors will place huge buy orders for an ETF, flooding it with cash, and the ETF will have to chase stocks trying to put that cash to work.
Strangely enough, the place where this liability exists is in the world of traditional open-ended mutual funds, where investors can drop huge amounts of cash into the funds at the end of the trading day. The fund has a responsibility to grant them the NAV struck just moments later, but must go into the market and buy shares the following day.
ETFs work exactly the opposite way. When authorised participants create new shares of an ETF, they must typically deliver to the ETF company the exact securities the ETF wants to hold. The ETF gives them an equal value in ETF shares in exchange. You can’t create new shares of an ETF if you can’t buy the underlying. That’s just the way it works, and to argue otherwise is to claim that up is down.
- 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.
There’s some truth to this, but only if you replace “ETFs” with “institutional money.”
Let’s look at the numbers: Traditional mutual funds have $11.2 trillion in assets, while ETFs have just $980 billion. The market cap of the S&P 500 is $10 trillion. One trillion dollars of that market cap is owned in indexes, and just $100 billion of that is in ETFs. That means that ETFs represent 1 percent of the market.
The Kauffman point argues that this doesn’t matter, because the constant trading in the baskets makes ETFs different, and in effect, “price setters.” I would counter that at least ETFs represent actual ownership of the underlying, unlike futures, which have been acting as the big-money price setters for decades. On any given day, the futures market trades 10 times the notional value of SPY: $100 billion a day vs. $10 billion. Who’s driving what?
From the beginning of the report, Bradley and Litan refer to ETFs as derivatives, throwing the label around like a scarlet letter the funds must wear. To call ETFs derivatives—any more than any other pooled vehicle—is simply wrong. To then paint them with a brush that should be reserved for true derivatives is simply a scare tactic.
- Short positions in ETFs are somehow magically different than short positions in any other security, and issuers should be forced to “create” shares for notional long exposure.
Issuers don’t create—APs create. The Kauffman study, like all the other reports we’ve debunked this year, just doesn’t get how this works. You can’t present “shorted” shares for redemption—you have to present settled shares. And if I have lent my shares out, I can’t redeem them. And I won’t try to, because I know they’re on loan.
Yes, that means that if there’s a panic to cover shorts, people will have to buy up shares of the ETF on the open market, or make new shares through creation. Yes, that means you could get a lot of buying activity in the underlying. Yes, that means—just like in any stock that’s heavily shorted—prices will go up when everyone runs to cover their shorts. But this has nothing to do with the ETF structure.
The proposal that the issuer magically “create” extra shares for the notional short exposure is frankly impossible. How would that happen? With whose capital? With what stocks? I’m chalking this one up to a misunderstanding of the basics.
- Intra-asset correlation is killing the capital markets, and killing IPOs.
We addressed this in a recent episode of our weekly podcast, after a recent report from Hennessee cried foul in the name of hedge funds. But the points are worth repeating.
Correlations between groups of stocks—say, small-caps and large-caps—are constantly shifting. Yes, we’re at a relative high in some cases. Yes, as more and more indexed money comes in—a trend we’ve seen since the ’70s—one would expect correlations to be high.
If, however, markets were becoming hugely inefficient, you would expect a huge upswing in private equity, where large companies would gobble up the “undervalued” small ones. We haven’t seen that. Private equity and M&A activity is down. We similarly haven’t seen small-cap active funds beating the indexes, which you would expect if there were gross misvaluations in the market.
Further, in times of crisis, all correlations go up, because investors become “risk on/risk off” investors, not stock pickers. This has happened in every bear market, and during every market crisis.
Kauffman suggests that this can be cured by allowing small companies to “opt in” to indexes. Leaving out the legal implications of this, consider: You’re the CEO of a small-cap company and have to choose between Russell adding you or having a bazillion dollars of institutional money buy your stock.
Which answer lets you keep your job?
- ETFs have high fail rates.
The report actually hits this one square on the head. This is bad and shouldn’t be tolerated. Reporting requirements for failed settlements in all equities, including ETFs, should be improved, and there should be more substantial consequences.
I understand that firms like Kauffman are nervous about the rise of exchange-traded funds in recent years. I get it—change is scary. But throwing all of indexing under the bus isn’t the solution to the problem.
The truth is there are any number of ways indexing has improved the market, adding a level of transparency and control that investors simply haven’t had before. The focus on index trading has put more importance on macroeconomic trends than individual securities, and while that changes the nature of investing, it’s a positive move.
It’s a brave new world and the less fear-mongering we have in it, the better.