A Casey Report interview with Dr. Andrew BoganDavid Galland --
Casey ResearchDr. Andrew Bogan is a managing member of Bogan Associates, LLC in Boston, Massachusetts. He has spoken at many international investor conferences – his specialty being global equity investing – and has been interviewed on live television for CNBC's Strategy Session. In an attempt to understand the relatively new but wildly popular Exchange Traded Funds (ETFs), Dr. Bogan did extensive research into the structures used by ETF operators, with a special focus on the potential risks that might arise should they be faced with large and sudden liquidations. Given that there are about 2,000 ETFs in existence, with assets totaling over $1 trillion, we thought it appropriate to find out what Dr. Bogan has learned in his research.David Galland: Our primary goal today is to give readers a better understanding of exchange-traded funds (ETFs) and the risks that come with them. Speaking personally, I've been in this business for a long time, and I find anything that grows as quickly as ETFs have a bit worrisome.
To begin, maybe you could just talk a little about the difference between an ETF and a traditional stock or bond mutual fund.
Andrew Bogan: Yes. Shares in a traditional mutual fund, whether it's an index fund or has a managed portfolio, don't trade in the open market. If you want to own shares, you buy them from the fund. If you want to get rid of your shares, you sell them to the fund.
A traditional mutual fund takes its shareholders' capital and invests it directly on a one-to-one basis in stocks or bonds and holds those securities in custody. Thus it's always 100% reserved, meaning that the securities it owns correspond exactly to the shares its investors own. If you want your capital back, the fund can deliver it to you either in kind or in cash, depending on market conditions.
That's not the case with an ETF. Shares in an ETF trade in the open market, which is where retail investors buy and sell them. An ETF also issues and redeems shares every day, like a mutual fund. But, unlike a mutual fund, it does so only through "authorized participants," which are brokers, market-makers and other institutions.
DG: Jumping right to the point, has there ever been a problem with an ETF?
AB: ETFs have operated pretty well historically, but the mechanics of share issuance and redemption also creates some unique differences that we believe may lead to unintended consequences.
There already have been a few problems with ETFs, some more significant than others. The Flash Crash on May 6 of last year showed some structural issues with ETFs and perhaps with our whole market system for equities as well. It's hard to decide where to draw the line, but a lot of securities departed from their perceived value during the Flash Crash by very large amounts. The reasons are still not completely understood, although the SEC has made a reasonable effort to understand what happened.
Another incident occurred in September 2008, when the Lehman and AIG mess was upon us. The commodity ETFs run by ETF Securities, Ltd., in London halted trading when AIG's solvency came into question. The funds were investing in derivative contracts, including swap agreements, some of which were with AIG. It was only the Federal Reserve pumping in tens of billions of dollars that prevented those products from going. Bailing out AIG averted a disaster for the funds, and they continued to trade the next day.
DG: So, the issue with the ETF securities fund was more around the derivatives the fund held, not the structure of the fund itself?
AB: In that particular case, it was around the derivative contracts that underlay the fund, although that kind of arrangement is very common with European ETFs. Even equity index ETFs in Europe tend to be structured that way, and that's also not uncommon with a lot of the foreign stock ETFs as well – including some of those traded here in the United States.
I think it's a clear example where you have a counterparty risk wrapped inside the fund that could be very significant in bad circumstances.
DG: In the case of the Flash Crash, your research paper pointed out that even though ETFs represent only 11% of the listedsecurities in the U.S., 70% of the canceled trades during the Flash Crash involved ETFs. Is there an explanation for that?
AB: Some clarity is starting to emerge from work done by the SEC and others. But from our perspective, those statistics are quite alarming. There's no good reason 70% of canceled trades would be in ETFs while only 11% of listed securities are ETFs. And even though ETFs trade more actively, they don't represent 70% of all trading volume. So any way you look at it, they were badly overrepresented among the canceled trades, i.e., overrepresented among the most extremely off-priced trades.
From the perspective of financial theory, that makes absolutely no sense. ETFs are meant to be index-fund trackers. They’re meant to represent a whole basket of shares, and yet these very securities that are meant to be diversified actually fell more than their underlying stocks during the Flash Crash, more often and more deeply.
That's quite worrisome; it tells you that in a crisis environment ETFs don't behave the way financial logic suggests they ought to, which suggests to me that the theory is incomplete. People haven’t really looked closely enough at what the unintended consequences of ETF issuance and redemption mechanics are, and what the realities are in stressful market conditions.
DG: At this point, more than half the American Stock Exchange's daily volume is ETFs, which is quite a number. These things have only been around for, what, less than 20 years. Yet from everything I've read, it seems they’re not very well understood, even by you guys. Which is saying something because you’ve spent a lot of time looking at them, and there are still blank spots in your knowledge about how they actually operate.
AB: Absolutely, and I think that's an important point. We understand the mechanics of how an equity trades and from where it derives its value and how it's priced in the market. The mechanics for mutual funds are well understood also. The challenge with ETFs is that the process of issuing and redeeming shares that also are trading is much more complicated than a lot of people want to talk about. It allows for some unintended consequences, particularly in connection with short-selling, which became an important factor only in the last decade.
DG: Let’s talk about the process of creating new shares. If I'm running an ETF that is designed to mimic the S&P 500 index and I have a lot of people who want to own my fund, I can simply issue new shares based upon the flow of stocks into my fund, right?
AB: Shares can be created at the end of any day if someone delivers a basket of underlying stocks to the ETF through an authorized participant. And shares that are not wanted in the marketplace can be redeemed in kind for the underlying stocks – or in some cases cash. That's all been carefully structured and works smoothly. The issue is what happens when short-selling dominates the trading.
People have been short-selling ETFs up to shocking levels, like 100% short, 500% short, sometimes over 1,000% short. That's in a world where stocks like Apple are 1% short, or IBM is 1.4% short, or General Electric is 0.5% short. You really don’t see traditional stocks with short positions anything like this, so clearly something is fundamentally different. The difference is that ETF short-sellers – including hedge funds, dealers and arbitragers – are confident they can always create the shares needed to cover, so they see less risk of being squeezed.
DG: But in a traditional short-selling situation, you typically have to borrow the shares before you can short them.
AB: Yes, and that's true here too. But if you look at the Securities Settlement Failure data, ETFs are very oddly overrepresented, so it does look like there is some short-selling that happens before the shares are borrowed. But that's a small matter. The problem is that there is no limit to the amount of short-selling you can theoretically do while still having borrowed the shares. It simply requires the same share to have been borrowed, short-sold, borrowed from the new owner and short-sold again down a daisy chain. That's how you get these arbitrarily large short interest figures.
The short-selling involves new buyers coming in without the shares being created at all, and that's the fundamental asymmetry in the short-selling that we're most concerned about.
DG: Let's get to that, because you have retail investors, for lack of a better word, and you’ve got the hedge funds. I suppose they could both own the same fund, but for completely different reasons; a hedger to hedge another bet, and a retail investor to pursue a certain goal, but the net result is that the short interest is still way out of whack from what you'd expect to see in a traditional stock. I suspect this is something that most of the retail investors are unaware of. So, where is the potential for the ETFs to get into trouble?
AB: The trouble could come from a number of different angles.
One concern is that the huge short interest building up essentially leaves the ETF as a fractionally reserved stock ownership system. If you have a fund, for example, that is 500% net short, then for every one holder of an actual share there are five other investors who own IOUs for the shares. Their real shares have been lent out and short-sold to someone else – usually without the original owner's knowledge, unless they read and still remember the margin agreement they signed when they opened the account 10 years ago.
For the ETF itself, it means that the fund holds only 15% of the underlying securities implied by the gross number of fund shares that investors think they own. The other 85% isn't totally missing, it just isn't held by the fund.
Morningstar commented that the money is all there, it's just in hidden plumbing in the financial system, and we agree with that exactly. The question is, how many investors understood they were storing their money in the hidden plumbing?
DG: So walk us through what might happen if there were large-scale redemptions. Let's just say that for whatever reason, people decided this was the time to get out of a particular fund. How do things get unwound?
AB: Redemptions have to flow through an authorized participant, which is usually a broker or market-maker, and it's only that institutional layer that can actually redeem. If for some reason a significant portion, say, half or 80% or so, of the total fund ownership wanted to redeem and get the underlying stocks from the ETF through the authorized participant layer, you would fundamentally have a crisis in a fractional-reserve system.
The ETF could not deliver the underlying stocks to all the would-be redeemers. The investors who really owned just an IOU on shares that had been lent to short-sellers wouldn't have a direct claim on the fund, so their demand to redeem would force an unwinding of the short-sales.
DG: So it seems that it's not so much the fund that might have a problem. The fund is only liable for the shares it has issued. The risk seems to lie in the counterparties – the brokers or the investors that brokers lent shares to.
AB: Right. Essentially you have just that. You have quite a bit of counterparty risk here, because if you think your shares can be redeemed and then the fund halts redemptions because they’re running out of the underlying stocks, you're stuck. Normally ETF shares are redeemable through the authorized-participant channel, but an ETF or any other institution that issues something that is redeemable but fractionally reserved could be hit with a run, like a bank run.
Now the big question is, in practice, would this happen? It's up to everyone to form their own conclusion, but interestingly the first argument we heard when we began looking into ETFs was that this was just a theoretical topic and that there would never be a really big redemption in a large ETF. But we have since learned that's actually not the case, because a giant redemption in IWM, one of the largest ETFs, occurred in 2007.
Now we think that 2007, being one of the best markets for equities since maybe the late ‘90s, was a pretty forgiving time to test the crashworthiness of an ETF that runs into a massive, unexpected redemption. But IWM was redeemed from millions of shares outstanding down to something on the order of 150,000 shares, and in one day, and that's because somebody tried to crash the fund.
DG: Was that a really lousy fund, and somebody just said, "Enough, I'm going to punish you guys and get out of it,” or –
AB: Oh, no, no, IWM is one of the largest and most liquid ETFs in the entire market. It's the Russell 2000 iShares ETF. It is the poster child of why ETFs are great. But even so, what's interesting is that the first argument we got from industry insiders was that our misgivings are nonsense, growing out of some theoretical conversation about what might happen but is never going to happen, and now we're being told it already has happened and nothing broke too badly, so what are we worried about.
DG: Let’s stick with this potential problem of a huge bunch of redemptions. People say, "Oh my god, I've got to get out of my ETFs," and there is a wholesale run on the funds. Because of the way ETFs are structured, it would seem that if they post net redemptions for a day, that the broker that had lent fund shares to short-sellers would just force the borrowers to buy back and cover their obligations.
AB: That's exactly right, but remember, for an ETF to create units requires someone to deliver the underlying stocks, so there's somebody who's on the hook to buy those stocks en masse all at the same time.
DG: No matter what has happened to the price in the interim.
AB: Yes, which gives rise to the question of who's on the hook and what's their creditworthiness when they get put on the hook. Have their prime brokers really been keeping appropriate track, as they’re required to do and on most days have done, of the creditworthiness of those, say, hedge funds or other kinds of short-sellers?
DG: Because you're not talking about small amounts of money.
AB: No. In fact, in one ETF, IWM again, short positions recently amounted to 14 billion dollars. That's not an enormous amount for the capital markets, but it's a pretty significant amount with respect to 2,000 small stocks. If there were a run, actually doing that unwind and getting those 14 billion dollars' worth of extra ETF shares would require buying 14 billion dollars’ worth of Russell 2000 stocks. If you didn’t want to be more than, say, 10% of volume, it would take 40 trading days to buy all you needed.
So we think that if you actually had a very sudden redemption run on IWM, there is a real likelihood of a short squeeze occurring in the Russell 2000. We don’t expect that at any particular time, it's just something that could happen if enough things went wrong.
The short position in an ETF like IWM being over 100% means that a large amount of the money investors think they have placed in Russell 2000 stocks has in fact been lent to hedge funds and other short-sellers. You take that across the entire ETF industry and you're looking at about 100 billion dollars in short interest – money that did not go into the underlying shares or gold or whatever the ETF represents. It was instead lent to hedge funds. It has been deposited in a shadow banking system where ETFs allow short-sellers to borrow money from institutional and retail investors.
DG: And what are they doing with that money?
AB: Well, no one knows. Presumably they invest it in what they think is going to make a better return than what they shorted, because you can't score the 10% or 20% those guys are all trying to make every year by buying the index. So it's anybody's guess.
DG: One question that Terry Coxon asked as I prepared for this interview was whether there is any way for the marketplace to let the fund's share price deviate for long from NAV?
AB: The tracking of an ETF's price with the fund's NAV, which historically has been extremely close, is totally dependent on an arbitrage mechanism. The arbitrager can make money by continuously pushing the price of the ETF toward its NAV. The question is... what NAV? What they mean by NAV is a value per share outstanding of the fund's underlying stocks. But of course you have this huge implied ownership through short-selling, and the short-sellers' shares are not being counted in the shares outstanding number.
DG: A lot of our readers have money in GLD, which is the ETF that invests in physical gold. You've looked at GLD, and it's based upon the premise that as investors pour money in, the operators of GLD turn around and buy physical gold and store it. And likewise with redemptions, they just sell the gold. My understanding is that there isn't anywhere near the same level of short interest on GLD.
AB: The short position in GLD isn't nearly as large as it is for some equity funds – but we have looked at GLD, and it has the same structural issues, just to a lesser extent, at least for now. The short interest in GLD has fluctuated around 20 million shares. Now, GLD is a pretty big fund. With 20 million shares short, it is roughly 95% fractionally reserved. So for all the investors who think they own the underlying physical gold, the fund actually has 95% of it in the vaults.
But GLD does not have to stay at 95% fractionally reserved. If there were a massive wave of short-selling in GLD, you could end up with a very significant fractional-reserve situation. If that were followed by heavy redemptions, you'd have the same kind of problem I described earlier – not enough gold to redeem all the shares.
DG: Could they just say, "From here on, we're not issuing any more shares"? Would that stop the short-selling?
AB: Not necessarily, because, you know, the short-sellers are selling – in fact, it would probably exacerbate the short-selling. So as long as a fund is issuing shares, aggregate buying demand can be satisfied by expanding the fund. If they stop issuing shares, aggregate demand would get satisfied by short-sales of existing shares. So, if anything, closing the issue window should make the problem worse, not better.
DG: Working through the mechanics of this, let's say gold drops by a few hundred bucks. Say, for instance, that there is some major change in the market along the lines of when Volcker raised interest rates back in '79-'80. And at that point a lot of short-sellers say, "Okay, this is it for gold," they pile on, they start shorting the hell out of GLD, and now all of a sudden you’ve got a real problem because the fractional aspect of it balloons, if you will.
AB: Well, you don’t necessarily have an immediate problem. It depends on the market conditions and the level of panic. You certainly would have a ballooning fractional-reserve situation, meaning that the reserves held in actual gold versus the implied ownership by people who think they own GLD (even though the shares have been hypothecated by the broker) will shrink. Those investors may believe they are still entitled to the metal, but the reserve of gold held on their behalf starts to shrink very quickly under those conditions.
The bigger challenge might be if there were an actual redemption wave. If that happened when GLD was already substantially fractionally reserved, then you're back to an 1800s gold bank problem. Fractionally reserved banks can be hit with a run.
DG: Right. Is there anything else that would make this whole "house of cards" collapse? Suppose a highly visible ETF stumbles and is unable to meet redemptions, or they just have to postpone redemptions. That might be the sort of trigger that could really send people off.
AB: You know, one of the big risks, by the way, that no one has really discussed much, is if an ETF were to have a big redemption run in panicky market conditions and halted redemptions. Halting redemptions is a complicated decision, because it breaks the symmetry that allows the arbitragers to go long or short both the basket of stocks and the ETF shares to move price toward NAV.
So it's quite possible that if redemptions were halted for any length of time, the arbitragers wouldn't be keeping the share price in line with NAV. We already know from the Flash Crash that significant price departures from NAV are quite possible for ETFs.
DG: Knowing what you do, I mean, obviously you deal on an institutional level with your money-management firm, do you own ETFs personally?
AB: We do not. We do not own any ETFs either personally or on behalf of the funds we manage.
DG: Is it because of the research you’ve done or just because it's not what you guys do?
AB: I would say it's primarily because it's not part of our strategy, but obviously we did the research because we were interested in understanding the product better.
DG: So, any advice for readers? Is there a short interest over which a person should be concerned about his holdings?
AB: Well, I don’t know if I could set a threshold, but I would certainly encourage people to make sure they know what the short interest is in any fund they are considering. That's a metric that is starting to become more accessible. Since we published in September, some of the ETF sponsors, like BlackRock, have begun reporting on ETF short interest, which I think is terrific – kudos to those guys.
We would like to see better transparency and disclosure, so that institutional and retail investors alike are aware of the counterparty risks that are "hidden in the plumbing," to use Morningstar's term, and are aware of the actual and somewhat complicated mechanics of the products that they’re buying.
DG: Do the ETFs with a mandate to magnify an index 2 or 3 times (e.g., RSW) have an elevated level of risk, due to the additional leverage?
AB: The underlying "assets" from which these funds get their NAV are derivatives to begin with, which introduces another layer of counterparty risk – one that has already experienced serious problems. We find it surprising that packaging complex derivatives in an exchange-listed security (the ETF) seems to remove all of the sophisticated investor standards usually applied to derivatives trading by SEC, CFTC, etc.
One ETF recently launched in the U.S. is PEK, the Market Vectors China A Shares ETF. This is another great example of where the industry is headed.
It is illegal for most foreign investors – except a few licensed global institutions – to buy A shares on Shanghai or Shenzhen, China's two mainland stock markets, and Market Vectors is not one of the exceptions. So instead of owning A shares, the ETF owns swaps with brokers that are licensed in China to own A shares. The fund holds the swaps as its underlying "assets." So PEK is an NYSE-listed China A shares ETF that does not own a single Chinese A share.
If PEK were to become significantly short in the secondary market, it would mean a fractional-reserve ownership of a derivative representing a basket of stocks that would be illegal for nearly all of the ETF's investors to own directly. More confusing still is what it means to be short PEK in the first place, since it has historically been illegal to be short A shares in China at all.
In essence, ETFs are being used to package and securitize products that are at best poorly understood and in some cases are used to circumvent securities regulations. An example closer to home is when the SEC briefly banned short-selling of essentially all financial stocks in 2008. The financial-sector ETFs were not on the list, so many hedge funds kept right on shorting financials using those ETFs.
DG: Certainly a lot to think about here. Any other questions I forgot to ask about, but that I should have?
AB: No, I think that was a pretty good coverage of a little bit of work we've done.
DG: Is there a good publication that would help people better understand the mechanics of the ETFs, because it is obviously very complicated, something that people might want to be able to study?
AB: Always the best place to look is in the fund's prospectus. The prospectuses are long and impenetrable, because they’re written by the legal team, but they really do have a tremendous amount of information. If you can float through one of them, I think it's definitely to your advantage.
DG: Thank you for your time.
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