ETFs Limit IPOs and Increase Risk? Not So Fast!

Last month, the Kauffman Foundation published an 85-page report that reached troubling conclusions about exchange-traded funds (ETFs). According to its authors, these popular investment vehicles prevent startups from easily tapping the capital markets, while increasing systemic risk.

ETFs have enjoyed spectacular success. According to the report, in 1995 there were four ETFs with $2.3 billion in market capitalization. At the end of September 2010, there were 3,257 exchange-traded products with a combined market cap of $1.2 trillion. In such a massive market, if there is a problem, it's a big one.

Do ETFs discourage IPOs?
The authors charge that ETFs are "undermining the traditional price discovery role of exchanges," especially for small-cap stocks.

According to the report, the popularity of index funds, and the massive piles of capital they now contain, has made stock prices highly correlated with one another. Because so many ETF investors own a piece of the same basket of stocks, if one stock rises or falls, many others are prone to follow it:

The July 2010 report by Empirical Research Partners, for example, illustrates that the stock prices of large capitalization common stocks now move in the same percentages and in the same direction 60% of the time -- a level exceeded only twice in 84 years (1929 and 2009). ... [C]orrelations have been rising for most of the decade, both in the broad market and within sectors like financials, capital goods, and transportation.

When wildly different stocks tend to move in unison, the market's clearly doing a lousy job of sorting those shares' real value according to their potential risks and returns. This creates a bad environment in which to launch an IPO, because if nearly every stock moves up and down in tandem with nearly every other stock, high-growth startups have a far smaller chance to soar in price when they first go public. Since these tiny, rookie companies are still riskier than big-name blue chips, losing the opportunity for outsized stock price appreciation makes them a lot less attractive to investors. Indeed, fewer IPOs are launching these days.

But is an overabundance of ETFs really causing this unusual correlation? Or could something else be herding the market en masse -- say, the perception of increased systemic risk? After all, correlation levels peaked in 1929, decades before ETFs ever existed. But the Kauffman report's authors point out that we now have an unprecedented mix of high correlation with low volatility. Since the market's not wildly swinging back and forth, they argue, investors' fear of systemic risk can't be making stocks move in lockstep.

This is an interesting theory. On the face of it, the idea that more money in index funds could lead to higher correlation seems plausible, but it's far from proven. Who says you can't have fear of systemic risk without high volatility? Who says that, if you have lots of ETFs and high stock correlations at the same time, ETFs are necessarily the cause, and high stock correlations the effect? Why couldn't something else -- say, the Fed's attempts to reinflate asset bubbles via quantitative easing -- be causing that high correlation instead?

The report suggests that we should allow small-cap companies to refuse inclusion in indices, and therefore in the ETFs and mutual funds which track them, in order to escape the cohesive pricing effect. But if you're the CEO of a company that just went public, wouldn't you want index-tracking funds to feel obliged to buy your shares?

Do ETFs increase systemic risk?
According to the report, under conditions of high volatility, ETFs are vulnerable to collapse:

As more ETFs are created, the risk grows that, in the event of a future market meltdown triggered by any number of possible causes, the rush to unwind the ETFs will aggravate any sell-off. Indeed, some creators of ETFs may not be able to honor their obligations. If those institutions or holders of ETFs are deemed sufficiently important or interdependent with other financial actors, the U.S. government could be forced again to make the agonizing decision whether to come to the rescue, as it did with AIG and a number of other large enterprises during the financial crisis of 2008.

The report argues that a sudden surge in the market could mean that the price of all the stocks that make up an ETF will rise faster than the price of the ETF's own shares, which implies that creating new ETF shares to meet demand would be a losing proposition. And when prices plunge, and investors want to pull money out of an ETF, the report fears that the folks running the ETF won't be able to sell those holdings at a high enough price to cover the cost of the redeemed ETF shares.

The report spends a lot of ink persuasively demonstrating that for many of the stocks held by the iShares Russell 2000 Index Fund (NYSE: IWM  ) , it would take a long time -- as much as 188 trading days, in the worst case -- to buy or sell enough shares to create or retire a 50,000-share unit of the ETF without causing big swings in the price of the underlying holdings.

But while this problem sounds scary in theory, given the way ETFs create and redeem shares in practice, the effects will likely be less than earthshaking.

ETF companies work with Authorized Participants (APs), which handle the share creation/redemption process and act as market makers for the ETF. Suppose one of those APs perceives sufficient market demand for another block of index-tracking shares. First, it assembles the underlying securities for delivery to the ETF company. Only after those holdings are in place will the company issue a block of new ETF shares to the AP. Similarly, if customers are selling more shares than they're buying, the AP can return blocks of ETF shares to the ETF company, in exchange for the underlying securities.

Under normal market conditions, this system self-corrects any price anomalies caused by supply/demand imbalances. If demand for an ETF is high -- if the price per ETF share is consistently higher than the value of the underlying holdings -- the AP has incentive to create additional shares by purchasing enough of the underlying equities, then tendering them to the ETF company for an additional unit. If demand is low, and the price per share lags the underlying value of the equities, the AP has incentive to buy a block of ETF shares, then redeem it with the ETF company in exchange for the underlying equities.

The Kaufman report is right about the APs' potential difficulty in creating or destroying ETF units when the market is highly volatile. But while the APs normally act as market makers for their ETFs, buying and selling surplus shares to ensure smooth trading, they are not obliged to make sure the ETF share value exactly matches that of the underlying securities at all times. If there's a sell-off, and the market irrationally prices the value of the ETF below that of the shares, the AP will normally buy ETF shares. But if the selling becomes a tsunami, and the AP loses confidence that it can sell the underlying securities for enough to cover what it'd pay for blocks of ETF shares, it will temporarily step aside, just as stock market-makers did during the so-called flash crash.

So when the market gets extremely volatile, index ETF shares might gyrate wildly -- just like the stock of any public company. But as long as the company issuing the ETF hangs onto the shares it gets from its APs, so that it can trade them back to the APs as blocks of ETF shares get redeemed, there's no material, inherent systemic risk involved. In short, nobody's going to go bust and need a government bailout.

Did ETF shorting cause the flash crash?
The report cites legitimately scary levels of short interest for some ETFs, including "six ETFs with more than 100% short interest and at least 13 ETFs with more than 5%."

There are two reasons why high level of short interest can be a problem. First, it increases the risk of volatility. When unwarranted selling starts squeezing the price of a stock or ETF, shareholders might panic and start a stampede. And when unexpected good news catches short-sellers off-guard, they may all simultaneously rush to buy shares and cover their positions.

Second, high short interest is intrinsically suspicious. Generally speaking, you can only borrow and short shares that you've bought on margin. The proportion of shares bought on margin (which include fully paid-for shares held in margin accounts) varies widely from equity to equity. However, it's not unusual to have difficulty finding marginable shares to short, even for stocks with less than a 5% short interest (which is considered high).

If short interest gets unusually intense, it may signal that people are selling shares they don't own and haven't borrowed from someone else -- a generally illegal practice known as "naked shorting." Mathematically, when short interest exceeds 100% of outstanding shares, there must be at least some naked shorting going on.

Thus, it's likely that illegal naked shorting's involved in most or all of the 13 high-short-interest ETFs the Kauffman report cites. However, naked short-selling is a problem for plenty of other investments besides ETFs. And in any event, finding short-selling issues with 13 out of 3,257 ETFs hardly constitutes a crisis.

Finally, the authors diligently try to prove that iShares' Russell 2000 Index ETF, along with the S&P 500-tracking SPDR Trust (NYSE: SPY  ) , set off the May 6 flash crash. They convincingly demonstrate that both ETFs were violently affected by the flash crash, along with hundreds of other equities. But they don't seem to have persuasive proof regarding who was in the driver's seat.

Dubious diagnosis, decent prescriptions
If ETFs were more prone than stocks to fail amid high volatility, that would be a major issue. Unless you believe that the report proves that assertion, it appears that most unleveraged long ETFs are no more vulnerable to a black-swan event than any stock in the S&P 500. In fact, since index ETFs spread risk among multiple equities, they're probably less risky than most individual stocks.

However, even though I think the report's criticisms of ETFs are off-base, I do consider some of the proposed remedies properly Foolish. For example, the authors attack the common broker practice of lending out marginable securities from their customer accounts to short-sellers. Suppose you buy shares of SPY, confident that the S&P 500 will rise over the long run. Your broker then quietly lends some of your shares to a short-seller, collecting fees and interest in the process. The broker keeps all the profit from those fees for itself, even though it's allowing the short-seller to use your own shares to effectively bet against the investment you've made.

While you can usually opt out of letting brokers loan your shares to shorts on the sly, most brokers won't advise you to do so. The report suggests that brokers shouldn't be allowed to lend out marginable securities from your account unless you explicitly approve such a move. If you do, the brokers should be obligated to split with you any money they make off the short-seller.

The report also calls for much more stringent enforcement of the rules against failing to deliver shares by the settlement date. (The authors claim that failures to deliver inordinately afflict ETFs; even if they don't, they're still a serious problem in general.) And they call for restrictions on anonymous, off-exchange "dark pool" trading, to eliminate front running and other abuses, and ensure that customer orders get priority.

Plus, they call for the virtual elimination of market orders; every order would be a limit order, either specified by the customer or determined automatically by standard rules. As they see it, market orders increase the potential for, and the likely damage from, flash-crash-like volatility.

The authors are not big fans of Sarbanes-Oxley, which is holy writ for some Fools, but some of their suggested tweaks to the legislation seem worth considering. For example, they propose giving the shareholders of micro-cap companies greater leeway in deciding how much of Sarbanes-Oxley to implement. For some companies, that choice may make access to the capital markets a viable alternative to selling out to a bigger, less entrepreneurial corporation. While some bad actors may slip through, greater flexibility for micro-caps could also enhance the capability of the system to nurture and reward innovation.

In general, it's probably fair to say that with the advent of ETFs, investors are paying more attention to macro-level considerations, and less to individual stocks. As advocates for entrepreneurs, the authors of the Kauffman report are not happy about that. But with America suffering from financial illiteracy, the popularity of ETFs could help more people start considering how big-picture issues such as the decline of the dollar will affect their portfolios.

Since ETFs can help investors form strategies based on the broader movements of the entire economy, it's ironic that these investments should be criticized for creating unintended, far-reaching effects that could potentially frustrate or sabotage those same strategies.

This particular report appears to overestimate the dangers of ETFs. But given these investments' relative newness, and the reality that not all of them have worked as well as investors might have expected, I'm glad to see thoughtful critics raising these sorts of issues.

We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

Guest contributor Brad Hessel currently has no position in any of the equities mentioned; however, Brad's clients may have such positions. The Fool's disclosure policy includes certain trading restrictions that apply to Brad. However, his clients are not subject to our disclosure policy, and thus are free to trade any such equities.

Read/Post Comments (12) | Recommend This Article (15)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 06, 2010, at 2:42 PM, BlackDragonFund wrote:


  • Report this Comment On December 06, 2010, at 4:37 PM, bhessel wrote:


    Well…generally speaking, for an index ETF to fail to track the underlying index for weeks or months or longer would most definitely be a serious marketing problem at least, and—depending on what kind of claims they make about their performance—perhaps even a regulatory issue or fodder for the scavenger lawyer packs who are always ready to sue equity managers over the slightest hint of poorer-than-expected performance.

    But the concerns raised by the Kaufman report focus on extreme conditions of volatility more likely to last minutes (as with the 6 May Flash Crash) or hours…or maybe days. No serious investor is going to lose faith in capability of an ETF to track its underlying index because it temporarily became unhinged on a day when Procter & Gamble (PG) stock prices ranged from $62 down to one cent and back again.

    Brad Hessel

  • Report this Comment On December 06, 2010, at 9:26 PM, CecilCockering wrote:

    In general, I agree with this analysis. However, I think that the analysis completely ignores the effect of having just an amazing company and getting great press for it before going public.

    I recently made an IPO with my start-up company, Cecil Cockering's On-Line Funeral Home Emporium (CCOFHE), and we were not affected at all by ETFs. We made serious bank my friend. It could be that, as you say, the ETFs are an overstated problem made by bored economists, but it could also be that when you wear Old Spice, people can tell, you know what I mean?

    My company hit on a terrific idea: many people want to go to wake's and funerals, but they don't like having to dress up or actually make the trip down to see ol Uncle Ted. So why not just stream these services on-line? Uncle Ted will certainly never know the difference (though his ghost may haunt you for eternity... but if he's that vindictive, you should probably have avoided him when he was alive). Once we launched this service, everyone wanted a piece of it... CNN, MSNBC, ESPN, etc., and we knew we were primed to go public. People knew it was a great idea and they wanted to invest; the rest of the market was irrelevant.

    It's true that we've had some problems post-IPO because of our add-on "coffin cam," but this still furthers my point: it's all about your idea and marketing of it, ETFs have absolutely no bearing.

    Respectfully Yours,

    Cecil Cockering

  • Report this Comment On December 07, 2010, at 5:24 PM, LindBond wrote:

    This is certainly an interesting analysis. I would also like to say that I agree with Mr. Cockering in the respect that having an amazing company and good press can make up for effects posed by ETF's. However, I respectfully add something to that statement. You must also diversify your product or service to some degree.

    In my experience, overspecialization is like the sword of Damocles hanging over a good business. Imagine overspecialization as wearing a hood over your head, with only a straw to breathe through. Yes, while at rest, perhaps, you may very well be fine. However, if you were to engage in any vigorous activity then you would find yourself out of breath and, very soon, of out oxygen. A company that overspecializes is breathing through a straw, so to speak. Yes, when the economy is booming business is good. But specialized items and services are luxuries of a sort. If the economy fails, then business would go down tremendously. This being the case, I do not believe that many people would invest in your company as they would not find to it to be a sound investment. I suppose, you might argue that you could just take off the hood when times are rough restricted by your capital (in handcuffs if you will). Unfortunately, this not always possible with most businesses.

    You see, my company -- named after myself, Lindsey Bond -- makes age cream. This was all good and well before the recession, but afterward we simply couldn't compete with the larger companies which not only had more capital -- aren't handcuffed, if you will -- but didn't just specialize in skin cream, but also other cosmetic products.

    However, we discovered that our product could easily be converted to good lubricant. Thus, we were able to salvage our business by also marketing it to mechanics, film directors, chemists etc., allowing us to secure our profits.

    In sum, as Mr. Cockering has said, an amazing business selling a good product, with good press can get around the effects of the ETF's, however it would also be advisable to find new uses that you could advertise, in order to sell your product or service, diversifying the consumer base, securing profits, and most importantly, raising investor confidence that your company is a good investment.

    If you wish to learn more about this, I will be having interviews on various networks and shows including, CNN, MSNBC, FOX, The 700 Club, and the Opal Show.

    Best regards,

    Lindsey Bond

  • Report this Comment On December 07, 2010, at 6:08 PM, CecilCockering wrote:

    Intriguing thoughts, Lindsey. I would like to note, however, that Cecil is sometimes a female's name; thus, I am Miss Cockering, not Mister.

    Respectfully Yours,

    Cecil Cockering

  • Report this Comment On December 07, 2010, at 6:21 PM, LindBond wrote:

    I see. I give you my deepest apologies, Ms. Cockering. It was rude of me to assume. Though, I admit that I had my reservations about making such an assumption. however it felt improper to refer to you solely by your first name, and strange to refer to you by your full name.

    I hope I have not offended you, Ms. Cockering.

    Best regards,

    Lindsey Bond

  • Report this Comment On December 07, 2010, at 7:36 PM, CecilCockering wrote:

    Do no worry Lindsey, you have two more strikes. In any case, I am eager to hear Mr. Hessel's take on my ETF-IPO thoughts.

  • Report this Comment On December 08, 2010, at 11:21 AM, bhessel wrote:

    Ms. Cockering,

    Thanks for your note. To be honest, however, it left me a bit confused as to whether the analysis you agree with was mine or the Kaufman report authors'.

    Both of us agree with your point that the stronger the company, the better the chances of [a] having an IPO and [b] rewarding the new public company investors with subsequent stock price appreciation.

    The Kaufman report authors contend that the existence of index ETFs, by dint of causing a more powerful asset class price cohesion effect, materially raises the bar, so that fewer innovative companies will be able to have successful IPOs and issue public shares that go on to exhibit growth-company-style stock price appreciation.

    While I grant that asset price cohesion is elevated and IPOs are down in comparison with historical norms, I am dubious of the theory that these are effect and that the recent growth of index ETFs is the cause.

    So congratulations on the success of your endeavor; alas it doesn’t do much to advance either argument. I can say, “See, IPOs are still happening under these conditions,” while the Kaufman report authors can say, “See, only outstanding IPOs are able to happen under these conditions.”

    Please write again if you succeed in taking a less-outstanding startup public. :-)

  • Report this Comment On December 08, 2010, at 12:39 PM, CecilCockering wrote:

    Mr. Hessel,

    To clarify, I agree with your analysis -- I just don't know why we're making such analyses. I think that we differ in our definition of "innovative companies." Is an innovative company one with an awesome idea or one that is able to survive a tough market, or something else? What leads to an "outstanding IPO?" My argument is that talking about the relationship between IPOs and ETFs is like talking about the relationship between IPOs and the weather. You're going to find something if you look hard enough, but ultimately it doesn't matter. Again, if a man is wearing Old Spice, I recognize it and want to invest in him, regardless of his ugly shirt or skin diseases.

    Respectfully Yours,

    Cecil Cockering

  • Report this Comment On December 09, 2010, at 1:29 AM, bhessel wrote:

    LOL perhaps the nub of our disagreement is that I am not an Old Spice user; in fact I actually *like* the natural smell of humans (and also cats, but not dogs).

    Which reminds me, you brought up the subject of the weather. I am currently out of the habit of jogging (recovering from a soccer injury) but normally I am pretty religious about keeping to a three-times-a-week regimen. Cats-and-dogs rain will dissuade me for a day or two but short of that I am out there. And being out there regularly, one naturally comes to recognize other runners, walkers, dogs, etcetera.

    Well, it seems I am the "CCOFHE" of neighborhood joggers: when the weather is relatively cold or wet or hot, many fewer of my fellow outdoorsfolk are in evidence.

    (Although there is no falloff in the canine population. And presumably because they can tell I don't like the way they smell, they all bark at me. And being male, naturally I bark back.)

    The point is that jogging, as with IPO-ing, is not a strictly binary event...or if you insist that it is, then I would point out that your tipping point -- where zero switches over to one for you -- varies from that of others. Thus, under ideal conditions, most jogger/startups attain their tipping points; under normal conditions, fewer. And when the weather is rotten, it's just you and me, babe. :-)

    The Kaufman authors and I agree that life on Earth should generally be better if conditions are favorable for IPOs because lowering the bar for the potential payoff encourages innovation (and those who would fund that activity). And it is in honor of that faith that we are constrained to discuss the weather -- or, more accurately, the climate -- for investing.

    It doesn't seem a relevant topic to you, because you are going to do your IPO regardless. But to those of us who want more startups to have that opportunity -- and for there to be more startups aspiring to reach the IPO tipping point -- the weather matters...and currently, both the Kaufman authors and I agree, it is bad.

    Brad Hessel

  • Report this Comment On December 09, 2010, at 3:13 PM, DrPepper4eva wrote:

    I find this discussion quite interesting and highly illustrative, but I'm puzzled by the focus on small cap IPOS. What of those big behemoths coming down the pipe? We all know the facebook IPO is something people are salivating over, but will its price fairly be reflected by these ETFs?

    On a more personal note I find the plight of small cap IPOs deeply troubling. I subscribe to a strict belief system that holds that the endtimes are rapidly approaching. While I find this prospect to be terrifying on a humanistic level, I also believe that these times could be quite profitable for the informed and prudent investor. I believe strongly that there will be a glut of new product offerings as companies are founded to organize and equip whatever survivors there may be. Certainly there will be quite a booming business in water purification systems and canned foods. Oh, and bullets, let's not forget about bullets. I imagine that I will be quite distraught if I learn that these IPOs have been dragged down with the broader market because of ETFs via satellite phone when I emerge from my cave complex (p.s., it's not where you'd think). I will likely also emerge to walk the dogs, glad you do that too, though I don't think it will smell too good out there at that point.

    Stay thirsty my friends.

  • Report this Comment On December 10, 2010, at 7:53 PM, LindBond wrote:

    I respectfully disagree with DrPepper4eva's business model. I mean: Why wait until after the end? There is a much larger market that could be tapped into beforehand. Also, I cannot imagine a current ETF -- the majority of which, I would reasonable assume, are staffed by sceptics -- would buy into an IPO which advocates stockpiling for the end of days? Of course, afterward there likely wouldn't be any ETF's left. But wouldn't it be better to accumulate capital now and use that to benefit yourself?

    Now, please understand that I am not suggesting that your beliefs are wrong or that your's a bad idea altogether. I am merely suggesting that you add-on a "pre-end times" part to your business model. Something subtle, perhaps.

    For example, it is my belief that people have a deep, repressed, Jungian fear of the eventual end of the universe. I believe, because of this repression, said fear is reduced to worrying about such things as the wearing down of both one's body and possessions.

    Thus when I started my company, I tapped into this fear with our product: Lindsey Bond's Age Cream, in hopes of taking advantage of this cosmically and collective fear of the heat death of the universe, manifested as the abhorrence of wrinkles. We tapped into the fear of the degradation of one's possessions, in conjunction with our philosophy of product diversification when we released our mechanical lubricant. As a result we were even able to secure the business of certain high budgeted film companies, who I assume work with highly mechanical props, in addition to the usual customers -- who I have mentioned in my previous post -- such as mechanics and chemists.

    We further tapped into this market but releasing our new age mask -- name pending as our previous designation seemed to produce violent laughter from our focus groups.

    The lesson here is that you can profitably tap into people's deeply primal and Jungian fears of "the end times" as swell as after the end times. Of course, you will need to be subtle, as people hold overtly apocalyptic predictions in contention with their need to believe that the status quo will be sustained indefinitely.

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