What is an ETF?
With the rise of robo advisers such as Betterment and the
word of mouth praises for how cheap and good it, more and more have dabbled in
ETFs, but many may not know much more than what the acronym stands for and how
it is a stock that buys a basket of stocks. Here is my ETF primer for my fellow
millennials and finance nerds.
According to Bloomberg analyst Eric Balcunas’s ETF
origin story, one of ETF’s inventors Nate Most said the idea of ETFs came
from commodity warehouse receipts. Given it is costly and difficult to move
commodities around the globe, commodity traders keep them stored at the warehouse
and trade the warehouse receipts around. ETF does the same thing, except the
commodities are stocks and they are stored at a custodian bank rather than in a
warehouse.
ETFs are essentially the same, except slightly more
complicated. To begin, the ETF issuer finds a fund custodian to store the
basket of stocks. The ETF shares are created off of the basket of stocks stored
at the fund custodian. Then, the ETF issuer finds a broker dealer bank to serve
as the authorized participant (AP) to help manage the size of the ETFs and the basket
of stocks stored at the custodian bank. For instance, if people want to buy more
shares of ETF than created, the AP may buy stocks and exchange them for newly
created ETF shares and sell these ETFs to the investors. Thus, the AP helped
increase the size of the ETFs and the basket of stocks stored at the custodian
bank. Similarly, if people want to sell their ETFs, the AP may buy ETFs and exchange
them for stocks from basket of stocks stored at the custodian bank. Thus, the
AP helped decrease the size of the ETFs and the basket of stocks stored at the
custodian bank.
If this again sounds like gibberish, here is an analogy that
might help. The basket of stocks is gold, the ETF is gold standard British
Pound, the ETF issuer is the Bank of England, the custodian bank is Bank of
England’s vault, and the AP is the Bank of England’s bankers. During the gold
standard era, one could theoretically go to the Bank of England to exchange one’s
British Pound into gold from its vault. As a result, gold and British pound are
interchangeable (this requires the ridiculous assumption that there is no
fractional reserve banking and there is enough gold to cover all the British
pound). Similarly, the ETF and the basket of stocks are the same because one
could theoretically exchange one’s ETF into the basket of stocks from the
custodian bank. Also, when Bank of England has more gold, it can issue more
British pound, which is no different from the ETF issuer creating more ETFs
when it has a bigger basket of stocks. This is how ETF works.
What are its risks? (More for finance nerds)
First, what if the gold in the vault is impure or fake? In
that case, the people who bought British Pound for the gold would have lost all
faith in their British Pound. They will rush to the bank to exchange whatever pure
or real gold in the vault and sell the rest of their British Pound. This could
happen to ETFs. Since many ETFs hold financial derivatives that mimic the value
of the basket of stocks rather than the actual stocks, it is possible that when
investors rush for the exit one day, the financial derivatives will fail to
mimic the value during extreme periods, leading to panic. Second, what if Bank
of England changed British Pound’s conversion to include silver because it ran
out of gold? In this case, people may also lose faith in their British Pound
and rush to the exit. This could also happen to ETFs. There have been instances
where too many people wanted to buy ETFs and not enough stocks to back them up.
In this case, the ETF issuer decided to add other stocks into their basket of
stocks so that they could keep on creating and selling ETFs. Third, what if many
new countries are formed and they all start creating their own precious metal backed
currencies? How will it affect the normal mining and trading of precious
metals? The liquidity of ETFs and stocks are now called into question as ETF continue
its explosive growth both in terms of size and number.
What are the implications of its risks? (definitely for
finance nerds)
If the financial derivatives that back up many ETFs fail or
lose value unexpectedly, many will take big losses. This may be just another
market sell-off like the dot com bubble or it could lead to a bigger financial
crisis where large systemically important financial institution are challenged.
One reason to feel downplay this risk is that the global ETF market is only
about $3
tn compared to the $240 tn total
wealth worldwide and it is unfeasible that all ETFs will suffer big value
losses due to the unforeseen risks mentioned above. However, one must also
refrain from being complacent. The supposed infallibility of Mortgage Backed Securities
led to the massive credit default swap bets on the side. While the MBS market
at the time was only $8
tn, the notional value of the CDS was around $60 tn! It is often
difficult to see the risks lurking in the shadows until it is too late. Lastly,
even if it is unlikely ETF will be a trigger of a financial crisis, it is possible
that ETFs’ explosive growth in terms of number and size have introduced changes
to the market ecology that increase the system’s vulnerability.
