Since 1993, the Exchange Traded Fund (ETF) industry has grown to include approximately 1,100 products representing $1.1 trillion in assets. In 2007, there were approximately 430 products with $430 billion in assets. During 2011, fixed income ETFs have drawn the greatest cash flows within the ETF universe, with $16.1 billion added during the first half of the year. With more money allocated to fixed income ETFs, volatility in response to interest rate fluctuations could intensify.

“But on the ETF side, there’s still this arms-dealer mentality…It’s, ‘We just make the weapons and what people do with them is their responsibility, not ours.’ ”
Don Phillips, of Morningstar The Wall Street Journal, April 18, 2011

Initially, ETFs replicated broad market indices as an alternative to index funds and invested in primarily liquid areas of the market. We have moni- tored the proliferation of ETFs, which now include strategies for narrow slices of the market, and less liquid types of securities. We are not encour- aged by what we see developing. The industry has manufactured an ETF for every taste, and has made it much easier for hedge funds and other high frequency traders to move in and out of positions during the day based on “macro trades” that ripple throughout the system. Leveraged ETFs and regular ETFs bought on margin can have a domino effect during a market selloff, with margin calls triggering more selling. ETFs are considered attractive because they can trade during the day, and can be shorted or bought on margin. Since we focus on fundamental investing and do not employ leverage, we do not find these reasons compelling. In this article, we discuss three issues that have led us to steer clear of ETFs.

  • Pricing issues
  • Implications for commodity prices
  • High-Frequency Trading (HFT) stacks the deck against individual ETF investors.

Pricing issues
The pricing and best execution of ETF trades is an important issue, and one that is not well understood. The individual investor assumes that all trades are at net asset value (NAV), and is not aware that ETFs can trade with a “bid/ask” spread that is part of the trading cost. With a traditional open- ended mutual fund, the NAV is calculated at the end of the day so that all investors get the accurate price. In contrast, ETFs can trade at a premium or discount to NAV during the day. Although ETF market makers are charged with buying and selling underlying assets in the ETFs during the day to quickly rebalance the portfolios, this attracts specialized trading desks that profit from discrepan- cies in prices. ETF market makers have the unique authority to create and redeem shares during the day; this differs from market makers for stocks,

The opinions expressed herein were formulated based upon facts and conditions known as of October 2011. Subsequent changes in facts and conditions affect our analyses, opinions and actions. which have a fixed number of shares outstanding. ETFs are the only kinds of investments that can both lend out their securities for short selling and be sold short. This creates situations of “net short” positions—the shares outstanding are less than the number of shares sold short, until the market maker creates more shares to restore equilibrium. There have been significant pricing issues during “flash crashes,” which have not been limited to May 6, 2010. According to the May 29-30, 2010 edition of The Wall Street Journal, ETFs represented approximately 70% of the trades cancelled (those which had a 60% or greater drop in price) during the May 6th flash crash. Further complicating the pricing of ETFs of overseas investments trading globally, trades can occur while the local mar- ket is closed. The risk is more acute in smaller, less liquid markets. During volatile trading days, the dispersion between NAV and the ETF’s price can become significant.

Implications for Commodity Prices 
Commodity ETFs that use futures contracts can experience performance that is very different from the performance of the underlying commodity. This has spurred the growth in physically backed ETFs, which attracted $77.6 billion by year-end 2010. Physically backed ETFs can have an economic impact. Commodities that are being warehoused by exchanges have been taken “off-market” for production of goods and materials, which af- fects supply and prices.

  • The February 7, 2011 edition of The Wall Street Journal’s article about this type of ETF noted that the price of silver was less than $10 per troy ounce in February 2006, before the launch of the first silver ETF (SLV). Since the launch of SLV in April 2006, the price of silver has tripled to the $30 range on September 30th, after peaking at a high of $48.58 earlier this year.
  • On June 13, 2011, The Wall Street Journal’s article “Miners Hit Back In Gold ETF Fight,” estimated that since 2003, gold ETFs have attracted $70 billion in assets that would otherwise have been invested in gold mining stocks, which pay dividends. Mining companies are increasing their divi- dends to regain the attention of investors. Several of our managers have in- vested in mining companies and other materials-oriented businesses, which have provided more attractive valuations.

HFT Stacks the Deck against Individual ETF Investors
Traders with sophisticated trading algorithms and specialized trading desks can generate more trading volume than the exchanges have been built to handle. ETFs have caught the attention of the SEC for their potential impact on the mar- kets, and the SEC has postponed dealing with requests by ETFs in the U.S. to invest in derivatives. We do not know to what degree ETFs are affecting mar- ket volatility; we are concerned that they are having an impact. High frequency trading is an area begging for more regulation and a “toll” or tax.

“You could say that [physical commodity ETFs] just take productive assets out of the system for no other reason than speculation…Recently, somehing like 80% of U.K. copper stocks was stuck in London Metal Exchange warehouses.”
Christopher Aldous, CEO of the London firm Evercore Pan Asset “Emerging Threat Funds”,

CFA Magazine, Sept-Oct 2011

Although ETFs can be useful to gain broad market exposure while a long-term strategy is being developed, we believe that fundamental investing is a superior approach over time. Our managers focus on investing in businesses rather than “markets.
The opinions expressed herein were formulated based upon facts and conditions known as of October 2011. Subsequent changes in facts and conditions affect our analyses, opinions and actions.

 

An original article authored by the Investment Research Group of Wescott Financial Advisory Group LLC
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