Where will the next point of instability be? Not what will trigger the next liquidity and credit crunch and cause the next landslide of panic selling and losses. We can already see many candidates for the trigger. But what will be the mechanism by which it is amplified and spread?
I think that in a couple of years, unless something alters the current trends in money flows, we will come to know ETFs the way we already know the securitization and packaging of sub-prime mortgages into CDOs. I think the signs are already there to suggest ETFs are where the instability and risk is accumulating. If I am in any way correct then ETFs will be to the next stage in our on-going state of siege-mentality crisis what CDOs were to the last.
To substantiate this claim I have to tell you in simplified terms what an ETF is. And then explain how, despite all the differences between mortgage backed CDOs and ETFs, the latter generally being based on stocks, bonds and commodities rather than mortgages, they are undergoing the same evolution from simple to opaque, stable to unstable, are being seen as the provider of liquidity and risk-controlled ‘exposure to risk’, just as CDOs were, when in fact they are concentrating risk and will, in a moment of panic, cause liquidity and lending to collapse.
In any ecosystem there are certain niches: large carnivore, carrion eater, arboreal fruit eater etc. These niches can persist even as the particular species that fill them go extinct. What you find is that another species, from a different family, will evolve into the niche because it is ‘empty’ and therefore there is ‘a job’ going free. So it is in the present ecosystem of global finance. In many ways the ETF is evolving, or being bred, to fill the same niche that Securitized debts (CDOs) filled only a few years ago.
Here is how a paper for the Bank for International Settlements (BIS) describes the rise of the ETF.
…in the low global interest rate environment in 2002–03, structured credit products [CDOs] were marketed to gear up investment returns for institutional investors …as they offered higher returns to comparably rated plain vanilla assets.
The financial crisis experience, however, dampened investors’ appetite for structured credit products. Yet the low global interest rates that supported growth in structured credit products have returned, with institutional investors facing similar problems to those back in 2002–03. This time, financial intermediaries have responded by adding some innovative features to existing plain vanilla investment funds. (P.1)
The ‘same problems’ the BIS mentions are that when interest rates are low banks can’t make much return by simply lending out money. So the desire for a higher return spurs the invention of financial products that promise that special combination of a higher return but without the higher risk that should come with it. Securitization and CDOs promised it. ETFs promise it.
So what is a basic ETF?
An ETF (Exchange Traded Funds) is an investment fund which holds a mix of stocks, bonds or commodities such that it emulates and thus tracks the over all value and performance of the particular exchange it is based on, such as the Dow or the NASDAQ. So when you buy a share in an ETF you are buying, as it were, a tiny, representative slice of all the stocks and shares, bonds or commodities which characterize the whole market. Just as a mortgage security and CDO was a way of buying a little slice of a pool of mortgages, so an ETF is made of ‘slices’ of a basket of shares, bonds or commodities depending on the kind of ETF. In both cases the ‘product’ is marketed as a way of investing in a basket of stuff so as to spread the risk that comes with buying all of one thing. Of course as soon as something is understood as a way of spreading or lessening the risk it is immediately seen as a way of ‘getting exposure’ to more risky things - in a less risky way of course. A less risky way of taking risks – the claim of modern financial innovation boiled down to its essence. So ETFs are marketed as a way of investing in less accessible and more ‘risky’ markets via a product that ‘smooths out’ the risks for you. To me these are the obvious parallels between securities/CDOs and ETFs, on the ‘risk’ side.
There are also parallels on the ‘liquidity’ side. As a recent paper by the Financial Stability Board (FSB) on ETFs says,
… their main advantage is to combine the low-cost diversification benefits of index-linked and basket products with the high liquidity and tradability of individual stocks.
What makes ETFs different from other kinds of investment funds, like Money Market Funds, is that shares in the ETF can be bought and sold like any other stock or share, on a second by second basis. Whereas Money Market Funds are redeemable and valued only once a day. Money Market funds are sometimes characterized, especially by those offering ETFs, as large, conservative and slow creatures. The herbivores of the financial world. Whereas ETFs are seen as faster and more responsive, combining the basket nature of a fund but with the instant tradability of stocks.
ETFs are also seen as increasing and therefore providing liquidity not only to the buyers in a market but to the sellers as well. Some of the biggest ETFs are based, in part at least, on shares from emerging markets which many investors would not know much about or dare to purchase. As the BIS paper says,
Investors’ desire to seek higher returns by taking exposure to less liquid emerging market equities and other assets through ETFs that guarantee market liquidity…. (P.1)
Thus an ETF listed and trading in NY may contain shares in Korean companies. Suddenly those more obscure Korean stocks are moving in NY. So ETFs claim to provide liquidity for buyers and sellers – the whole market. Good for you, good for me – good for everyone.
So that is a very simple sketch of ETFs and some of the claims made for them. The important point for me is how ETFs are in many ways slipping in to the niche left vacant by Securitized products like CDOs. Same sorts of claims about safety versus risk, and about providing liquidity. ETFs and those who run them are, it seems to me, positioning themselves as not only good and safe, but by being liquidity providers being also systemically important for the health of the broader market. Sound familiar at all?
ETFs were invented back in the 90′s. The first ETF was on the Toronto exchange in 1989. It was 1993 when the first ETF appeared in America. By 2002 there were 246 around the globe. They continued to grow but so long as the securitized, mortgage backed CDOs reigned supreme the ETF was its poor relation. With the collapse in demand for securitized, mortgage-backed products, the ETF, I think, is poised to emerge as the successor. In 2005 ETFs held a mere $410 billion in Assets Under Management (AUM). Enter the crash and the heart-attack contraction in Securitization, and by 2010 ETFs had tripled to $1.3 Trillion Assets Under Management and are growing.
Large as this sounds it is worth keeping in mind that the ETF market is actually still small, just 5% compared to the much more established Mutual Fund market. But we are still in the early days of the rise of the ETF. The equivalent, I would guess, of where Mortgage backed securities and CDOs were in 2002 or earlier. It is the rate of growth, not its size which seems to me to tell the story. The ETF industry has grown at 40% a year over the past 10 years! The broader market has achieved 5%.
ETFs are big, getting bigger and are everywhere in every market tracking every sort of asset from simple stocks, to corporate and sovereign debt and commodities from gold and oil to wheat and soya. According to the FSB paper from which I’ve already quoted (P.2) at the end of 2010 there were 2500 ETFs offered by 130 companies, traded on over 40 exchanges.
Now before I start on what I consider to be the dangers I want to make it clear that I don’t think ETFs are necessarily a bad thing. But just as with Securitization they can become a very bad thing. I also don’t think disaster is upon us with ETFs. But I do think they we can see signs that they are a possible, even likely venue for the same unwise, unsafe, unstable accumulation of ignored risk and systemic instability.
Reasons not to be cheerful.
So here is a brief and necessarily incomplete look at some of the reasons I think ETFs are becoming dangerous. Disclaimer – I am not an expert in ETFs. As with everything I write it as an educated person who has read what he can find and has tried to think clearly about what he has read. Nothing more.
When ETFs began they were what is now referred to as plain vanilla or physical ETFs. Such ETFs replicate the broader market by simply buying a representative basket of the shares which make up the market . The ETF’s creator/Sponsor gives this basket a company name and then creates and sells shares in that name, which people can buy and sell. So the ETF owns shares of all sorts of companies in the market. You do not – not directly. You buy and own shares in the ETF. Please note, because it will become critical later, that there are two markets and two sets of shares which the ETF sits across. The ‘primary market’ as its known is populated by ‘Authorized Participants’ which for the vast bulk of ETFs are the small club of global banks and brokers we have all heard so much about in the last few years. They buy or borrow (often from Pension Funds) the stocks and shares which will make up the ‘basket’ which they then put into a Trust. That Trust is then the issuer of the ETF. The Trust then creates what are called ‘Creation Units’, which are blocks of tens of thousand of individual shares in the ETF, which it gives back to the Authorized Participant. The Authorized Participant then either keep these shares as an investment for themselves or sell them on the ordinary , or as they call it, the ‘secondary market’ to ordinary buyers who wants to own an ETF share.
A couple of points to note. The shares in the Trust which issues the ETF shares are very often borrowed from Pension Funds who are and remain the actual owner of the shares. The ETF shares issued against the ‘borrowed shares held in the Trust’ therefore do not confer actual ownership of the underlying shares so much as a ‘legal claim’ upon them. You can read more on this line in this paper from NASDAQ. You may wonder why ETFs have this complicated double layer of shares – those it borrows or buys to make the basket and those it then issues to investors – and the reason is tax. No cash is being exchanged, it is all shares for shares at every step. This means there is no tax to be paid on any of the transactions.
However this tax efficient structure – which is the essence of the ETFs advantage over Mutual funds, presents what I think is the first overlooked problem.
Pinch Points in the ETF markets
Above I noted that as of the end of 2010 there were 2500 ETFs offered/sponsored by 130 companies, traded on over 40 exchanges. Which sounds like a healthy, broad based, liquid market. The Sponsor is the company that starts the whole thing, when it puts forward the plan for an ETF, gets that plan approved and manages it. However look a little closer and you find only 6 companies Sponsor and control 80% of the market. Or to put it another way 80% of the market in ETFs globally, relies on the health and solvency of just 6 companies. Not a wide base then.But it gets worse.
Here is a list of the big 6 ETF sponsors and who owns them.
i Shares = Blackrock. No 1 in ETF world with $670 B Assets Under Management (AUM).
State Street Global Advisors = State Street Bank and Trust. $2 T AUM. No 2 ETF with $283 B in ETF assets.
Vanguard = Specialist ETF company based on Pennsylvania.No 3 ETF. $204 B
Lyxor Asset Management = Soc Gen. with €85 B AUM in 1688 funds
db x-trackers = Deutsche Bank
Powershares = Invesco. A US company HQ in Atlanta but incorporated in Bermuda.
So of the 6 companies who are most of the ETF market two are drawn from the ranks of the Global banks which have had to be bailed out.
However the Sponsors are not alone. The Sponsors rely for the heavy lifting of buying and selling the shares – market making in other words – on the Approved Participants to buy/borrow the stocks. Sadly, from the point of view of widening the risk base of the ETF markets, the Approved Participant are drawn from the same short list of global banks and brokers as are the Sponsors.
Here, for example, is a list of APs for an ETF called ‘Greater China’ run by State Street Global Advisors who are the second largest ETF manager in the world:
So 80% of the ETF market relies on the solvency of only 6 companies who sponsor and manage them. They rely in turn on the handful of Global banks whose solvency and stability we already know was in a crisis, and still largely is, and remain totally dependant on Tax payer bail outs.
So how much stability do the APs bring to the ETF market? Well do you remember the ‘Flash Crash’ back in May last year when global markets suddenly experienced a crash in values that was caused by computer driven, High Frequency Trading? A study done by an ETF analyst revealed that 70% of the securities whose trades were cancelled that day were ETF shares. 70%! The study concluded that reason the ETFs froze and in doing so froze the markets was because the Approved Participants (the club of Global Banks and Brokers) froze. As the analyst said,
If those parties [the APs] are going to be paralyzed in the face of adversity, then the product [ETF] suppliers will have to qualify every statement they make regarding the liquidity and price efficiency of ETFs.
The article went on to point out,
Which, in other words, means the ‘flash crash’ may have shown ETFs to be particularly vulnerable in the event large sell-offs and liquidity lapses precisely because of their structure’s dependence on market makers and authorised participants.
Precisely! A huge market reliant upon 6 sponsor companies who in turn depend for liquidity in their market, upon a just a handful of the same old banks and brokers, half of whom are themselves chronically insolvent bail out merchants. Now to be fair there are a larger number of other companies who also act as market makers in the sense of being very active traders but who are not APs and therefore do not contribute to the critical actual initial buying of shares to create the ETFs. Nevertheless they do contribute to the liquidity of minute to minute trading – not that they helped at all in the flash crash. So who are they, that we might find some comfort from them? You can find a list of UK market makers here. It contains 28 names. 15 are … the same large bailed out banks: Bank of America/Merrill Lynch, Barclays Capital, Commerzbank, Credit Suisse, Goldman Sachs, HSBC, JP Morgan, Morgan Stanley, Nomura, Rabobank, RBS, Societe General, UBS and UniCredit.
Just like the Securitized mortgage/CDO market before it, the ETF market is constantly folded back on itself so that it relies always upon the same few players. At every stage the health, liquidity and operation of the ETF market is tied to the same very small number of very large players. And the flash crash clearly demonstrates how fragile and thin their liquidity providing and risk absorbtion actually is.
This theme of how everything is constantly tied back to the same players is what I will return to in part two, because it gets so very much worse. So far all we’ve really looked at are just the general weaknesses of the plain vanilla market.
In the next part we will look at the huge rise in what are called ‘synthetic’ ETFs which are based not on owning shares but on derivative swaps contracts. We’ll look at who the counterparties are of all those derivative contracts. I’ll give you one guess.
Then we’ll look at how those risks have been increased by the creation of ‘Leveraged ETFs’ which promise 2 or 3 times the possible returns but at the cost of doubling or tripling the risks as well.
Then, in case anyone thinks that the Vanilla/Physical ETFs, based on owning the underlying shares, are, by comparison with Synthetic ETFs, not really a problem, we’ll look at how the physically-based Vanilla ETFs increasingly lend out the shares they ‘own’ in order to make more money.