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Are ETFs a house of cards?

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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.

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Comments

  • Albermarle
    Albermarle Posts: 27,896 Forumite
    10,000 Posts Seventh Anniversary Name Dropper
    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. 
  • Thrugelmir
    Thrugelmir Posts: 89,546 Forumite
    Part of the Furniture 10,000 Posts Name Dropper Photogenic
    edited 21 April 2020 at 7:08PM
    Hardly new news. The risks have always existed. 
  • Username999
    Username999 Posts: 536 Forumite
    500 Posts First Anniversary Name Dropper
    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.
  • Alistair31
    Alistair31 Posts: 978 Forumite
    Seventh Anniversary 500 Posts Name Dropper
    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.

    What?
  • Username999
    Username999 Posts: 536 Forumite
    500 Posts First Anniversary Name Dropper
    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.

    What?

    Vanguard LifeStrategy 100% Equity A Acc

    TOP HOLDINGS (29/02/2020)
    RankLargest Holdings%
    1VANGUARD US EQUITY INDEX19.40
    2VANGUARD FTSE U.K. ALL SHARE INDEX A ACC GBP19.20
    3VANGUARD FTSE DEVELOPED WORLD EX-UK EQUITY INDEX A19.10
    4VANGUARD FUNDS PLC S&P 500 UCITS ETF GBP13.10
    5VANGUARD EMERGING MARKETS STOCK INDEX FUND8.50
    6VANGUARD FTSE DEVELOPED EUROPE EX-UK EQUITY INDEX A8.10
    7VANGUARD FUNDS PLC FTSE 100 UCITS ETF4.80
    8VANGUARD JAPAN STOCK INDEX ACC GBP4.60
    9VANGUARD PACIFIC EX-JAPAN STOCK INDEX ACC GBP2.30
    10VANGUARD FUNDS PLC FTSE 250 UCITS ETF0.90
    One person caring about another represents life's greatest value.
  • Barry_Bear
    Barry_Bear Posts: 212 Forumite
    100 Posts Second Anniversary Name Dropper
    edited 21 April 2020 at 8:26PM
    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.
  • Alexland
    Alexland Posts: 10,183 Forumite
    Eighth Anniversary 10,000 Posts Photogenic Name Dropper
    edited 21 April 2020 at 8:45PM
    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.
  • Barry_Bear
    Barry_Bear Posts: 212 Forumite
    100 Posts Second Anniversary Name Dropper
    edited 21 April 2020 at 8:47PM
    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?
  • Alexland
    Alexland Posts: 10,183 Forumite
    Eighth Anniversary 10,000 Posts Photogenic Name Dropper
    edited 21 April 2020 at 9:05PM
    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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