ETFs Are Mispriced
Preamble
Exchange traded funds, at their onset, provided new and valuable ingress for investors. Daily liquidity is an additive feature for investors, and the financial instruments made access to passive market exposures attainable at low expense. Some of the larger, and broader-based ETFs still provide that utility. However, the more than 500 net new ETFs created over the last five years have altered the industry’s value proposition, replacing inexpensive access with thematic or sovereign speculation, often with leverage.
Cocktail party conversations have been a financial industry barometer for many years. Boasts can be informative regarding investor sentiment. We imagine the cocktail party conversation today being something like this:
“I’m long the Direxion Daily Financial Bull 3X Shares ETF (NYSEARCA:FAS) and the Deutsche X-trackers MSCI Europe Hedged Equity ETF (NYSEARCA:DBEU), but I’m offsetting those positions with the ProShares Ultrashort Dow 30 ETF.
What do you own?”
“I own Amazon.”
“Oh, ****, I need to refresh my drink.”
Are investors profiting from turning their investment portfolios into global macro hedge funds? Are investors and their advisors equipped to shift between long and short exposure, country and industry exposure, and thematic and volatility plays, or are many of these moves just gambles? New risks created by ETF proliferation may not be well accounted for in present portfolio construction methods.
Numbers Game
According to Bloomberg, over 200 ETFs launched last year alone, increasing the number of outstanding ETFs to over a thousand. The nearly 20% increase in exchange traded funds is evidence of the popularity of the financial instrument. Previously less active in this market, big financial institutions have entered the ETF space in 2016. Fidelity, Morgan Stanley, John Hancock and Franklin Resources are among the large asset managers with new ETF products. New ETF launches are on pace for a record in 2016.
Putting these aggregate ETF listings in stock benchmark terms, there are more than twice as many ETFs as there are stocks in the S&P 500, considered a broad market index. There are more ETFs than there are stocks in the Russell 1000 index, which is inclusive of stocks ranging in size from $525 billion down to $1 billion in market capitalization. ETFs are beginning to outnumber liquid stocks. Having an “ETF market” supersede the stock market is not a remote possibility, and adding a layer of financial structure between investors and ultimate ownership of assets is not a positive.
Related to the absolute number of ETFs outstanding, trading volume of ETFs has become a material component of the market. Credit Suisse reports that ETF trading is averaging close to 28% of daily volume on the stock market this summer. While that stock market volume is substantial itself, option market volume is even more pronounced. ETFs now account for 70% of equity option volume. With this degree of option volume, ETF users must either be speculating extensively, or they must feel a need to control risk with these investment structures. On the speculation side, both Oppenheimer and LPL Financial were recently fined millions each for extensive and unsupervised use of leveraged and inverse ETFs in customer accounts.
Counterparty Risk
With over a thousand exchange traded funds attempting to transact in the underlying stocks, there may be occasions where cash flows into or out of an ETF exceed a company’s ability to transact in the underlying securities. ETF managers have anticipated this exigency, and have provisions in place to deal with it. Many ETFs permit “synthetic” positions. Synthetic positions are options or futures contracts that represent the underlying securities.
Some more exotic synthetics create a portfolio of securities that look and act like the intended purchases but without being those exact stocks. Synthetic products have been around for years. In good times, they allow asset managers to expand their business beyond constraints encountered in the market. In bad times, these synthetics introduce counterparty risk. Counterparty risk is the risk that the person or entity on the other end of the contract (the seller if you are the buyer) will not be able to deliver the goods. It depends on the counterparty’s own credit situation, as well as the number of exposures they have to you and others. Many ETFs have counterparty risk.
The UK Telegraph says it this way:
So, while retail investors may think of ETFs as a safe and easy way to get access to an index, commodity or bonds, they must remember that they are very complex products. Some ETFs use derivatives, or financial contracts, to get exposure to the underlying assets such as oil, gold or shares. This means that should anything go wrong with the ETF, investors would then be exposed to the financial health of the company that guarantees those derivatives, or contracts – unlike simply buying shares or bonds, where the investor is exposed only to the health of the underlying company invested in.
Redemptions of ETFs may result in some surprises for investors as well. Several ETF-defining documents allow for redemptions “in-kind.” Redemptions in-kind permit the ETF manager to deliver to customers their pro rata portions of the securities owned by the fund. In so doing, the ETF manager does not have to make sales and deliver cash for investors who elect to sell the shares.
This is another method of dealing with cash flows (out in this case) in excess of the available liquidity in the market for the underlying stocks of an ETF. There is risk to the ETF investor of having to sell these stocks or bonds on their own, likely at greater commission costs.
High Failure Rate
It costs an asset manager about a million dollars to open an ETF. Once established, it takes about a third of that sum to operate the fund on an annual basis. Fund expenses vary widely, but picking 50 basis points as a representative figure, a manager would need more than $60 million in assets in each ETF to break-even after administration, custody, trading, legal, and compliance costs per out calculations. (At lower fees, the assets under management needed for break-even are higher).
Today, there are at least 300 ETFs with assets under management below $60 million. That’s 300 ETFs, or about a quarter of the industry, which are likely losing money. Money-losing businesses tend not to have longevity in our view.
Given the relatively high hurdle for profitability, ETFs can have a short shelf life. 99 ETFs closed in 2015, following a year in 2014 where 88 ETFs shut down. That means nearly 10% of listed ETFs closed in each of the last two years, and those were good years. Data from etfdailynews.com shows a 23.3% mortality rate for ETFs over time. In either case, the rate of ETF de-listings far exceeds the roughly 2% annual rate of stock de-listings. Moreover, when ETFs do close, some charge termination fees to clients. With either in-kind or cash redemptions, investors may have work to do to reallocate funds from terminating ETFs. Given the failure rate of ETFs, re-investment plans would, of necessity, be part of an ETF investment strategy.
Stock-Like Volatility
Since they are generally pools of stocks or bonds, ETFs are seen by investors as less volatile investment instruments than individual securities. Evidence indicates, however, that ETFs have wide bid-ask spreads at times, and they do experience flash crashes. Two dates particularly stand out for dislocations in the ETF market, May 23, 2012 and August 24, 2015.
Zack’s details a break in the ETF market on Wednesday, May 23, 2012. On that date, at least two ETFs experienced dislocations. The iPath Long Enhanced MSCI Emerging Markets ETN (NYSEARCA:EMLB) maintained a bid-ask spread of over $14.00 on that trade date. The iShares MSCI Kokusai Index Fund had a different problem, trading volume. This fund with about $500 million in assets traded only 10,000 shares that day. There are other funds that had very low liquidity on that date as well. Illiquidity, even occasional illiquidity, may merit a risk premium.
Three years later, Investors got another rude awakening. On Monday, August 24, 2015, several prominent ETFs experienced a flash crash.
ETFs are supposed to-and generally do-trade in lockstep with the stocks they own. Yet when the S&P 500 fell as much as 5.3% in the opening minutes of trading, the $65 billion iShares Core S&P 500 ETF (NYSEARCA:IVV) fell as much as 26%, some 20 percentage points below its fair value.
IVV was not the only one. SPLV, ironically the PowerShares S&P 500 Low Volatility ETF, dropped 46%. The iShares Select Dividend ETF (NYSEARCA:DVY) dropped 35%, the Guggenheim S&P 500 Equal Weight ETF (NYSEARCA:RSP) dropped 43%, and the PureFunds ISE Cyber Security ETF (NYSEARCA:HACK) dropped 35%. ETF trading prices separated from the underlying value of the securities they were purported to represent, and trading was halted on these and other ETFs.
Due to the fact that ETFs are freely and individually traded (except when halted), they need not maintain a constant relationship between the ETF and the stocks or bonds represented by the fund. In fact, differences happen frequently enough that successful ETF arbitrage strategies exist. ETF arbitrage involves exploiting temporary differences in the price of an ETF in comparison to the price of the underlying securities.
If the ETF is expensive in comparison to the security portfolio adjusting for ETF management fees, an arbitrageur would sell the ETF and buy the corresponding securities, looking to profit from the difference in prices. With professional investors attempting to profit at the expense of investors unaware of spreads between ETFs and asset pools, investors assuming that the market price for an ETF is “correct” are at a disadvantage.
Absent an assessment of spread risk, ETF investors may over or underpay for representative holdings in the underlying securities at any given moment. In this difference, JAG sees a quantifiable risk for the ETF investor.
ETFs suffer from ubiquity, and that they are often mispriced due to counterparty risk, high failure rates, and volatility. Are these risks measured and controlled in your ETF portfolio? We suspect not.
These comments were prepared by Joe Kinnison, a representative of JAG Capital Management, LLC, an SEC investment advisor. The information herein was obtained from various sources believed to be reliable; however, we do not guarantee its accuracy or completeness. The information in this report is given as of the date indicated. We assume no obligation to update this information, or advise on further developments relating to securities discussed in this report. Opinions expressed are those of the advisor listed as of 8/18/16 and are subject to change without notice. Opinions of individual representatives may not be those of the Firm. Additional information is available upon request.
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