Bogan Associates LLC made a name for itself in the passive investing community by warning about an ETF collapse. The argument is pretty technically but, at its simplest, it argues that an ETF which has (a) a large number of short positions; and (b) is subject to a large number of sale orders could not have enough cash to pay out all the investors (the more technical explanation is provided by Bogan Associates who explain how short selling can lead, in some situations, to more units than issued by the issuer itself).

John Heinzl is one of the many writers who have argued against Bogan Associates theory that ETFs can collapse. What is interesting about Heinzls article is that Bogans highly technical piece appears to have made it to main street as iShares admits it fields calls daily about the possibility ETFs imploding.

But lets look at the larger contextual issue. ETFs may have a particular  issue if too many investors attempt to sell in a particular series of circumstances (if you agree with Bogan Associates analysis which is subject to debate). But, if there is a large run on ETFs, it most likely stands to reason that there will  be a run on mutual funds and the market as a whole. After all, ETFs and mutual funds are funds that track the market. Panicked investors dont sell based on products lines. They sell based on sector or market conditions.

(There will be situations where a poorly designed or thinly trade ETF- think the Egyptian and Tunisian Equities Market ETF if one exists-  is subject to a large number of sell orders while the market itself is doing well. In that case, even if Bogan Associates analysis does come true, one questions the wisdom of someone who bought such a product in the first place; it is not the short sellers who did the investor in. It is bad strategy and tactics).

If we assume that an inordinate amount of sell orders hits a highly popular ETF- popular enough as to affect most ETF holders- mutual fund holders, subject to the same impulses and emotions as ETF holders, are most likely issuing redemption requests to the mutual fund company. In such an event, either the mutual fund has to sell all their positions (remember in what may be a panicked and declining market) or apply liquidity brakes; many mutual funds set limits to how much money it will redeem within a period of time.

Can a redemption risk sink a mutual fund? Of course, it can.  In 2008, the American government had to create The Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility. A fancy name for a program to help money market funds fulfill redemption requests they otherwise could not meet since some money market funds held short term corporate paper which was unsellable for a time.

Similarly, shareholders who want out are attempting to sell shares in a declining market- or a market that does not want to buy a loser. A shareholder may not face the same technical issues as a ETF or mutual fund holder but it may be equally stuck.

I am neither a dogmatic advocate of passive or active investing. There are weakness in the design of both mutual funds and ETFs.  What I am trying to point out is that one of the conditions set out by Bogan Associates, an issuer subject to large number of sell orders, may be symptomatic of a much larger issue affecting the entire market and, in that case, we all have larger problems than those damn short sellers.  Accordingly, call iShares and asking is my ETF going to implode? misses the much larger point.

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