From the November 2010 issue of Research Magazine • Subscribe!

November 1, 2010

Assessing ETP Integrity

Expert Gary Gastineau assesses the integrity of exchanged-traded produts.

Having surpassed the $800 billion mark, the exchange-traded products (ETP) market (including both funds and notes) is now officially an 800 pound gorilla. But as $1 trillion in assets becomes the next destination, what’s ahead for the business?

Unfortunately, a disproportionate number of exchange-traded funds were snagged by the May 6 “Flash Crash.” Also, a number of ETFs have been forced to liquidate this year because of anemic assets and trading volume. How can advisors avoid these pitfalls and stay ahead of the pack?

Gary Gastineau, author of The Exchange-Traded Funds Manual 2nd Edition (2010, Wiley) visited with Research to analyze the current state of the exchange-traded products market along with its future. As principal of ETF Consultants, Gastineau also consults for ETF issuers and exchanges. Here are excerpts from the interview:

ETF critics have used the May 6 Flash Crash as an opportunity to claim the structural integrity of ETFs is faulty. What’s your take?

The problem on May 6th was a market structure problem, not an ETF structure problem. Anyone who lost money as a result of the Flash Crash on May 6th lost it because of the way the market was structured, not because of the way his ETF was structured.

The attention that regulators, the press and investors have paid to the “Flash Crash” is certainly appropriate. We have every right as investors to expect that our markets will function effectively, even when they are subject to stress. Some simplification is inevitable, but the events of May 6, 2010 highlighted a problem with the market structure that has been fixed by some of the new rules. The structural problem was basically that the market makers for most ETFs post their bids and offers only on NYSE ARCA systems. Under the rules in effect on May 6th, the slowdown/shutdown in trading on NYSE ARCA effectively shut down virtually all access to these market makers.

A large fraction of customer ETF trades interact with market makers. With market makers out of the loop, there was nowhere for many customer orders to find a counterparty. The rule changes that require equity markets to halt trading in concert should prevent a repeat occurrence.

While anticipating market structure problems is difficult, we need to do a better job of anticipating this kind of weakness in the market structure. To its credit, the SEC is making a greater than usual effort to anticipate possible future problems in high volume markets. To do our part as investors and advisors, we need to learn that using stop orders without a price limit can be very dangerous in an unstable market environment. A market order is probably safe if you’re trading the S&P 500 SPDR, but marketable limit orders are probably safer for all conventional intraday ETF orders.

As I argue in the trading chapter in the book, investors should avoid market-on-close orders for ETFs. Resting limit orders are not a particularly good idea in any electronic market because aggressive traders will use your limit order as their private stop loss protection and trade against your order. Your resting limit order will be executed only under circumstances when you would probably rather it not be executed. The introduction of net asset value based trading late this year or early in 2011 will enable many investors who are not comfortable trading in rapidly moving markets to use resting limit orders relative to net asset value and to trade with greater comfort and a clearer understanding of their costs of trading.

Transparency is something typically lauded; however, in the management of an ETF’s underlying securities portfolio, it can also be a two-edge sword. How widespread is front-running and what kind of impact can it have on ETF investors?

In Chapter 5 of the book I take great pains to distinguish between desirable transparency in costs and in the general content or character of the portfolio and undesirable transparency that enables scalpers to trade ahead of the portfolio composition changes that are made in all index funds. Most users of index funds don’t realize the cost of the latter kind of transparency. The belief that any fund can be transparent in terms of its day-to-day composition changes is one of the great weaknesses of indexing. The pioneers of indexing argued that the most appropriate way to manage your money was to buy a broad sampling or even the entire market portfolio in miniature; do as little trading as possible in response to corporate changes and other developments over time; and, consequently, keep your costs low. Unfortunately, most indexing dollars are invested in the various component funds that make up in the S&P 1500 and the Russell 3000 index families. This concentration leads to enormous costs associated with transparent implementation of index composition changes. This impact is going to increase in significance in the months ahead.

After the new edition of The Exchange-Traded Funds Manual went to press, Vanguard introduced ultra-low expense ratios on new ETFs based on the popular capitalization and growth and value segments in the S&P 1500 and Russell 3000 index families. With Vanguard’s S&P 500 ETF at a 6 basis point expense ratio and some competitive response likely from State Street and BlackRock, the concentration of index investments in these S&P and Russell indexes is inevitably going to increase. Investors and their advisors continue to focus on fund expense ratios as if the expense ratio represented the only relevant cost.

I ordinarily avoid making market predictions, but I am confident that the S&P 500 will be the best performing U.S. large-cap index for the rest of 2010 and probably for 2011. This performance will come from money flowing into low expense ratio S&P 500 ETFs. After the inflow slows, the performance penalty associated with high market impact from index composition changes will reverse the S&P 500’s relative performance.

The rapid growth of ETFs has been followed by expansion in the ETN marketplace. Today, there’s around $11 billion in U.S. listed exchange-traded notes. What’s your view of ETNs and what do financial advisors need to know about them? (Also, from an asset allocation perspective, do you count ETNs as bond exposure? Or should they be counted as the asset they track?)

I have not seen an analysis of the impact of the Lehman bankruptcy on the small number of investors who did not react to widespread warnings to get out of Lehman’s ETNs, but the events of the past several years have made most investors acutely aware of the credit risk associated with ETNs. It seems clear that investors and their advisors will only be willing to hold ETNs from banks or other issuers with strong balance sheets.  If you watch the credit quality, ETNs can be useful.

As to how an investor should categorize an ETN in summing up his asset allocation, the answer seems clear to me: if there is enough concern about your credit exposure to the issuer that you even consider counting the ETN as corporate bond exposure, you have probably taken on some credit risk that you are not being paid to accept.

Comparing mutual fund performance relative to a peer group of funds is rampant in the mutual fund industry, yet you argue that it doesn’t give an accurate perspective of performance.

My argument on this specific point is, first, that selecting a relevant mutual fund peer group is difficult and, second, that there are a variety of ways to obtain exposure comparable to the portfolio of a particular mutual fund that are not included in any evaluator’s peer group. Another important weakness in this process is that mutual funds are rarely evaluated relative to ETFs and ETFs are rarely evaluated relative to mutual funds.

I feel that if you must make a performance evaluation of a single mutual fund, the most useful comparison is usually to an ETF based on an appropriate index.  The reason to use the ETF for comparison is that the ETF has expenses and an index does not. We have a long way to go to develop good fund evaluation techniques, but comparing ETFs to mutual funds will be an inevitable part of the solution.

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