Individuals have gone ga-ga over ETFs as a means to gain exposure to broader markets, asset classes, or industries without having to dip in and pay for the underlying.
But the cost of these ETFs might be a future collapse, according to a post this weekend from FT Alphaville.
What we found most interesting was that ETF investors may not actually own a representative share of what the believe they do.
Take the SPDR S&P Retail ETF (NYSE: XRT) as an example. The number of shares short was nearly 95 million at the end of June, while the shares outstanding of the ETF were just 17 million. The ETF was over 500% net short! Or to look at it from another perspective, the ETF’s operator, State Street Global Advisors, believed that there were 17 million shares of the SPDR S&P Retail ETF in existence and owned shares in the S&P Retail Index portfolio to underlie those 17 million ETF shares. But, in the marketplace there were another 95 million shares of the ETF owned by investors who had purchased them (unknowingly) from short sellers.
And this situation could end up exploding as investors find out they don’t actually own anything.
In both cases the share buyer, however, is completely unaware his ETF shares were purchased from a short-seller and no doubt assumes the underlying assets in the index are being held by the ETF operator on his behalf, but no such underlying stock is actually held by anyone. Clearly this creates a serious counterparty risk and quite possibly the potential for a run on an ETF—where the assets held by the fund operator could become insufficient to meet redemptions.
The potential fallout from this sort of scenario is massive.
At recent prices the unfunded remaining ownership in the marketplace for which nobody currently owns any shares would be over $3 billion for just this one ETF! Extend this hidden unfunded liability from massive scale short-selling of ETFs (both traditional and naked) across the entire ETF spectrum and it is a $100 billion potential problem.
So what this means is that ETF investment you think you are buying to represent an underlying group of equities may not actually be able to be redeemed in the event of a run on the ETF.
But what would trigger a run on an ETF? If there were to be a dramatic fall in a particular exchange, say a flash crash due to malfunctioning algorithms, investors may decide to pull their money out rather than wait.
If in the case of the SPDR S&P Retail ETF that is about 17 million shares. But there are way more people who believe they own the real thing out there. If “owners” were to try to redeem more than 17 million shares, the whole thing could go haywire.
There is serious dispute of this theory questioning if, whether, if there was too much demand for redemption what would actually occur. The reality may be that shorts are able to purchase new shares of the ETF issued to payout to the longs. But the rebuttal to that is that the shorts are so large on some of these ETFs, that redemption may become impossible.
The debate can be read in the comments at FT Alphaville. But tthis is surely a subject worth paying attention to.