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Saw this interesting article. I don't personally know all that much about ETFs, but I was wondering what you guys thought.

From the Financial Times:

Kauffman: ETFs are the problem, not HFT
Posted by Izabella Kaminska on Nov 08 21:00.

Finally, a report that dares to outline the previously-taboo: Exchange-Traded Funds may pose a greater systemic threat to markets than high-frequency, or algorithmic, trading.

Writing for the Kauffman Foundation, a Kansas City-based private and nonpartisan foundation, authors Harold Bradley and Robert E. Litan lay the case out in a 86-page report on Monday. Both these guys have testified to the US Congress on things like market structure and financial crises, so they're well worth listening to.

At issue, they say, is the price discovery process itself:

We show here that ETFs are radically changing the markets, to the point where they, and not the trading of the underlying securities, are effectively setting the prices of stocks of smaller capitalization companies, or the potential new growth companies of the future. In the process, ETFs that once were an important low-cost way for investors to assemble diversified stock holdings are now undermining the traditional price discovery role of exchanges and, in turn, discouraging new companies from wanting to be listed on US exchanges.

That is not all. The proliferation of ETFs also poses unquantifiable but very real systemic risks of the kind that were manifested very briefly during the 'Flash Crash' of May 6, 2010. Absent the ETF-related reforms we outline below in this summary, and in more detail in the text, we believe that other flash crashes of small capitalization company "melt ups," potentially much mroe severe than the one on May 6, are a virtual certainty.

More after the jump: http://ftalphaville.ft.com/blog/2010/11/08/397431/...

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Comments (17)

  • Frieds's picture


    No. Not in the least bit. ETF trading had an effect on the flash crash, but they were not the fault. That's like blaming Waddell and Reed because they had 75,000 ES contracts trade during the crash.

    The issues with ETFs are related to 1) Correlation and 2) Hedging which create a systematic risk to the system when you add in HFT and Algo trading.

    The first problem is easy, as most ETFs take a basket of stocks and trade them in a long only fashion for the most part, and hedge themselves with basic options to create a bit of downside protection via covered writing. The problem here, however, is that in additions to ETFs taking concentrated positions, you have large funds who enter these positions as well or use large ETF holdings to create a position in a given space, thus the the correlation in movement increases outright because these stocks start trading closer and closer to each other (meaning that if there's a sell off in Apple, there will be a sell off in Cisco).

    The second problem comes down to Hedging, particularly with the levered ETFs. By employing derivatives and rebalancing positions at the end of the day to reflect any key changes due to the market conditions, you can gain significant leverage to magnify the upside and downside, however, when a shift to the market happens where there is a significant upside or downside movement, like what happened on May 6th, the fund managers begin the rebalancing process and trade accordingly with E-Minis, Options and other derivatives to keep balance in the position, added further strain in the markets.

    That's the problem with innovation, as no one has any idea what needs to be done to appropriately fix any of the problems. ETFs are not necessarily a problem, but are affected, like everyone and everything else by systematic shocks to the market. It's the way of the world.

  • monkeysama's picture

    I get the feeling that the ETFs are having a similar problem as tranching and MBS had. They're supposed to reflect an underlying security and offer all sorts of risk benefits from pooling, but instead just create more confusion in the market by adding disinformation. For example, the articles I linked to said that one of the problems was that because of the way ETFs are structured that instead of ETF moving with the stocks they represent, heavy bidding in ETFs can cause the stock prices themselves to follow the ETF price. From there swings in the ETF price can sway the markets and add tons of volatility.

    Also, just want to give a shout out to Frieds. Great Post! +1

  • Frieds's picture


    I really am torn about whether it's a tranching issue or not because you definitely see it when you play in the levered and short space because of the inherent reliance on derivatives, but not so much in the nonlevered area. You are definitely right about ETFs figuring into price movement, however the thing no one mentions is the biggest ETF of them all, the SPY.

    That one security is surprisingly telling when you discuss ETFs. It's an unlevered fund that trades according to the index itself, supposedly, in all 500 stocks. To bring light to what you said and how influential and ETF can be, the SPY tells that tale. Watch the trading for the SPY and graph it verse the VWAP (Volume Weighted Average Price - For those that don't know, VWAP is a Moving Average Price that is used to reflect the price and size of trading across the entire day as a weighted average of the equity instead of just by the price of a security. It's a surprisingly good way to see the divergence in an equity and an interesting arb opportunity as well if you are willing to try and bet of the divergence between VWAP and the actual pricing). It tells two very distinct tales and really illustrates how you can shift the market with trading an ETF, as it doesn't take much to move the market higher despite not having a similar VWAP tracking behind it.

    Oh, and thanks for the SB. If you wanna discuss, hit me up via PM. I'm always up for good discussion.

  • WallStreetKid's picture

    I heard WSO caused the flash crash.

  • In reply to WallStreetKid
    monkeysama's picture

    I heard WSO caused the flash crash.

    Yo momma so high frequency she caused the flash crash.
  • In reply to monkeysama
    blastoise's picture

    I heard WSO caused the flash crash.

    Yo momma so high frequency she caused the flash crash.

    yo momma so fat she dosen't taste the rainbow she eats the mfing rainbow

  • Frieds's picture

    SB for you Squirtz. Best old school yo mamma joke I've heard in ages~

  • In reply to blastoise
    happypantsmcgee's picture

    midas i almost have more nanners than u :D

    I just laughed for a good 2 minutes at this squirtz (you'll always be squirtle to me)

    If I had asked people what they wanted, they would have said faster horses - Henry Ford

  • monkeysama's picture

    I'm giving a banana because anyone who wishes to reduce this board to his own childish level has my overwhelming approval. Cause that's how I roll.

  • shorttheworld's picture

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