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Are ETFs a house of cards?
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Barry_Bear
Posts: 212 Forumite

The following points in an FT article highlight some disturbing concerns.
Could this apply to gold, commodity, and bond ETFs as well as equity index trackers?
What should retail investors look for when choosing an ETF, or does the following apply to all?
ETF like iShares, SPDRs etc are used by "authorized participants" that can create or redeem large blocks of new shares in an ETF (called creation units). ETFs are popular for large scale short-selling because short sellers need not be concerned about the availability of shares outstanding when they sell an ETF short—since they can always create new shares using creation units to cover short positions.
So while a retail ETF owner believes their ETF shares represent ownership of the underlying shares in fact ETF shares often far outnumber the actual ownership of the underlying index equities by the ETF operator.
This has led to some ETFs having shockingly large short interest as compared to their number of shares outstanding.
As an example 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. 78 million of those ETF shares were naked short–the short seller had promised their prime broker to create those non-existent shares if necessary to cover their short in the future. 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.
Could this apply to gold, commodity, and bond ETFs as well as equity index trackers?
What should retail investors look for when choosing an ETF, or does the following apply to all?
ETF like iShares, SPDRs etc are used by "authorized participants" that can create or redeem large blocks of new shares in an ETF (called creation units). ETFs are popular for large scale short-selling because short sellers need not be concerned about the availability of shares outstanding when they sell an ETF short—since they can always create new shares using creation units to cover short positions.
So while a retail ETF owner believes their ETF shares represent ownership of the underlying shares in fact ETF shares often far outnumber the actual ownership of the underlying index equities by the ETF operator.
This has led to some ETFs having shockingly large short interest as compared to their number of shares outstanding.
As an example 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. 78 million of those ETF shares were naked short–the short seller had promised their prime broker to create those non-existent shares if necessary to cover their short in the future. 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.
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Comments
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As the old saying goes 'do not invest in anything you do not understand ( 90% anyway) '
I shy away from ETF's for this reason after reading how it all works behind the scenes and not really understanding it.
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Hardly new news. The risks have always existed.0
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Albermarle said:As the old saying goes 'do not invest in anything you do not understand ( 90% anyway) '
I shy away from ETF's for this reason after reading how it all works behind the scenes and not really understanding it.
Difficult to avoid ETF's if you have funds from the likes of Vanguard.
One person caring about another represents life's greatest value.0 -
Username999 said:Albermarle said:As the old saying goes 'do not invest in anything you do not understand ( 90% anyway) '
I shy away from ETF's for this reason after reading how it all works behind the scenes and not really understanding it.
Difficult to avoid ETF's if you have funds from the likes of Vanguard.0 -
Thrugelmir said:Hardly new news. The risks have always existed.5
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Alistair31 said:Username999 said:Albermarle said:As the old saying goes 'do not invest in anything you do not understand ( 90% anyway) '
I shy away from ETF's for this reason after reading how it all works behind the scenes and not really understanding it.
Difficult to avoid ETF's if you have funds from the likes of Vanguard.Vanguard LifeStrategy 100% Equity A Acc
TOP HOLDINGS (29/02/2020)Rank Largest Holdings % 1 VANGUARD US EQUITY INDEX 19.40 2 VANGUARD FTSE U.K. ALL SHARE INDEX A ACC GBP 19.20 3 VANGUARD FTSE DEVELOPED WORLD EX-UK EQUITY INDEX A 19.10 4 VANGUARD FUNDS PLC S&P 500 UCITS ETF GBP 13.10 5 VANGUARD EMERGING MARKETS STOCK INDEX FUND 8.50 6 VANGUARD FTSE DEVELOPED EUROPE EX-UK EQUITY INDEX A 8.10 7 VANGUARD FUNDS PLC FTSE 100 UCITS ETF 4.80 8 VANGUARD JAPAN STOCK INDEX ACC GBP 4.60 9 VANGUARD PACIFIC EX-JAPAN STOCK INDEX ACC GBP 2.30 10 VANGUARD FUNDS PLC FTSE 250 UCITS ETF 0.90 One person caring about another represents life's greatest value.2 -
So with that Vanguard fund, which is a fund, not an ETF, there is still exposure to ETF risk.
The Lifestrategy funds are among the most popular funds for retirement planning for retail investors.0 -
The physical replication ETF creation and redemption process, in which baskets of securities get exchanged for ETF shares, runs between APs and fund managers and is robust in that the fund manager will be aware and hold all required underlying assets for any real ETF units.
The risk occurs when buying any exchanged traded asset that you are buying from a short seller who is naked in that they don't have the asset to deliver on the deal as they are relying on their ability to buy (eg Amazon shares) or get an AP to work with the fund manager to create (eg ETF shares) enough units to complete the trade. During this time the buyer is at risk of a failure to deliver occurring. However once the shares are delivered they are yours and the ETF fund manager will be aware of them and hold the required underlying assets.
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So what's all this "creating" extra ETF units about?
Who does this and why do they need to create units that don't exist rather than buying or holding from the pool of ETF units that are already issued and being traded by retail investors?0 -
The creation and redemption of ETF units by APs swapping baskets of underlying securities with the fund manager is essential to ensuring that the ETF valuation doesn't deviate into a premium or discount. This is how an ETF differs from a closed ended Investment Trust which might trade at a difference to the underlying net asset value.
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