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October 24, 2014 at 05:27 AM
Classically an exchange-traded fund is a derivative: It’s a contract whose value is based on the value of a basket of underlying stocks. (Bonds, whatever.) The contract trades on an exchange — thus the name — and so it has a trading price, but it also has a value that you can calculate.1 You can replicate it by buying the underlying stocks, or hedge it by selling them. So the value of the ETF is very well defined and transparent, and its price should closely reflect that value. That’s nice!
In addition to being a derivative, an ETF is also the cool way for cool people to invest in stocks. Mutual funds are lame: They have lots of expenses, you can only buy or sell them once a day, you have to pay capital-gains taxes, many of them are even actively managed. ETFs are sleek and awesome and efficient-markets-y. So they’re growing, as a class, faster than mutual funds,2 and they have a marketing appeal that old-timey actively managed mutual funds lack.
Most of the time there’s no reason to distinguish between these two ways of thinking of an ETF. They work together. The derivative mechanics allow the cool-stock-investing tool to work: Because the ETF can be replicated and hedged, market-makers can constantly provide liquidity in ETFs by offering to buy your ETF shares from you (or sell them to you) and then hedge by selling (buying) the underlying components. The trading keeps the price accurate, so the price tracks the value. It’s a paradise of liquidity and zero-arbitrage pricing. It’s a derivative that makes the world better for regular investors.
But there are disconnects. On the one hand, there are ETFs that are less “cool way to invest in stocks” and more gee-whiz derivatives structuring, giving regular investors exciting ways to lose money trading levered products that they don’t understand.3 And on the other hand, there are ETFs that are basically mutual funds and don’t really work as derivatives, but are nonetheless marketed as ETFs because ETFs are cool; that is how branding works.
The Pimco Total Return ETF, for instance, combines the cool branding of ETFs with the formerly cool branding of the Pimco Total Return Fund, but trades in odd lots of illiquid bonds and can’t really be replicated with much confidence by market makers. But actively managed mutual funds are so 10 years ago, and the temptation to make them into ETFs is strong.4
Once you’ve gone that far you might as well go further, or so BlackRock and Precidian thought, incorrectly.5 The Securities and Exchange Commission this week rejected their applications ”to start the first non-transparent ETFs.” A non-transparent ETF is a contract that trades on an exchange and whose value is based on the value of a basket of underlying stuff, but you don’t know what’s in the basket.
The basket is actively managed by BlackRock or Precidian, and the ETF provider tells you every 15 seconds how much it’s worth, but the contents are a secret.6 Basically it’s a regular actively managed mutual fund that you can buy and sell all day.
There’s nothing obviously wrong with that as a concept. I don’t own any ETFs, but I own shares in some mutual funds, even some active ones. If I want to buy or sell I do that at the end of the day, buying from or selling to the fund itself at the net asset value that the fund reports. But if at noon I wanted to sell you some of my shares, and you wanted to buy them, and I was happy to sell at $20, and you were happy to buy at $20, what would be wrong with that? I mean, mechanically, probably lots of things — that’s not really how mutual funds operate — but it doesn’t, like, affront my sense of how markets work.
I have a thing, you want the thing, we each make a reasonable guess about how much it’s worth, our guesses overlap, and we come to an agreement on price. We don’t know the value of the shares, exactly, but that’s true of almost everything in life. (Certainly it’s true of buying and selling shares of regular companies, which is why people keep doing it.)
And the non-transparent ETF is actually a bit better than that: Like other ETFs, it would distribute an updated estimate of net asset value every 15 seconds so you don’t have to guess too much at the value.7
So a non-transparent ETF seems perfectly reasonable as a cool way to invest in stocks. (Bonds, whatever.) But it’s not a derivative. Or not a good one anyway; it’s a contract whose value is based on the value of a basket of stuff (this is secret) and that BlackRock/Precidian can change at any time. It’s hard to replicate, or hedge, the mind of a money manager, or even her portfolio if she won’t tell you what’s in it.8
So the derivative structure of the classic ETF, which allows for instant liquidity and a price that always closely matches the value, is broken in the non-transparent ETF.
And the SEC said no on more or less those grounds. Here are the SEC’s letters rejecting BlackRock’sand Precidian’s applications. They basically say, this derivative is totally dumb, it doesn’t work, don’t do it. From the BlackRock one:
The Commission preliminarily believes that, even under normal market conditions, market makers could be unable to deconstruct the portfolio holdings of a proposed ETF with sufficient accuracy in order to construct a hedge portfolio that is closely aligned to the NAV per share of the ETF. The proposed disclosures by the Applicants would likely be useful in narrowing down the pool of securities and other assets that may be held by the ETF, but only to a limited extent.
So the price of the thing in the market couldn’t be arbitraged to its underlying value. That’s bad for price discovery. It’s also bad for trading costs. Here’s another thing the market makers said:
They indicated that they would likely use the pieces of information provided by the Applicants (IIV, quarterly portfolio holdings disclosure and prospectus disclosure) to construct hedge portfolios using sophisticated algorithms. Their ability to construct hedge portfolios that are generally predictive of the portfolio holdings of the ETF is critical to their management of their exposure to the ETF. If there is a break in the alignment between the market makers’ hedge portfolios and the NAV per share of the ETF, the market makers’ risk of loss increases. The greater the risk of loss, the more the market makers will seek to cover that risk by quoting wider price spreads of the proposed ETFs. This would result in market prices, at which investors would buy and sell the ETF shares, not being at or close to the NAV per share of the ETF.
I don’t know if “sophisticated” is the market makers’ word or the SEC’s,9 but there you go: This structure would create uncertainty for market makers, which would lead to wide bid-ask spreads.
Also everything is just too slow:
Market makers operate at speeds calculated in fractions of a second. In today’s markets, 15 seconds is too long for purposes of efficient market making and could result in poor execution.
