Submitted by Andrew Bogan of Casey Research

Are ETFs Really Safe?

Dr. Andrew Bogan is a managing member of Bogan

Associates, LLC in Boston, Massachusetts. He has spoken at many

international investor conferences his specialty being global equity

investing and has been interviewed on live television for

In an attempt to understand the

relatively new but wildly popular Exchange Traded Funds (ETFs), Dr.

Bogan did extensive research into the structures used by ETF operators,

be faced with large and sudden liquidations. Given that there are about

2,000 ETFs in existence, with assets totaling over $1 trillion, we

thought it appropriate to find out what Dr. Bogan has learned in his

research.

David Galland: Our primary goal

today is to give readers a better understanding of exchange-traded funds

(ETFs) and the risks that come with them. Speaking personally, I’ve

been in this business for a long time, and I find anything that grows as

quickly as ETFs have a bit worrisome.

To begin, maybe you could just talk a little about the difference between an ETF and a traditional stock or bond mutual fund.

Yes. Shares in a traditional mutual fund, whether it’s an index fund or

A traditional mutual fund takes

its shareholders’ capital and invests it directly on a one-to-one basis

in stocks or bonds and holds those securities in custody. Thus it’s

Another

incident occurred in September 2008, when the Lehman and AIG mess was

upon us. The commodity ETFs run by ETF Securities, Ltd. in London

halted trading when AIG’s solvency came into question. The funds were

investing in derivative contracts, including swap agreements, some of

which were with AIG. It was only the Federal Reserve pumping in tens of

billions of dollars that prevented those products from going. Bailing

out AIG averted a disaster for the funds, and they continued to trade

the next day.

DG: So, the issue with the ETF securities fund was more around the derivatives the fund held, not the structure of the fund itself?

worrisome; it tells you that in a crisis environment ETFs don’t behave

the way financial logic suggests they ought to, which suggests to me

that the theory is incomplete. People havent really looked closely

People have been

short-selling ETFs up to shocking levels, like 100% short, 500% short,

sometimes over 1,000% short. That’s in a world where stocks like Apple

are 1% short, or IBM is 1.4% short, or General Electric is 0.5% short.

You really dont see traditional stocks with short positions anything

like this, so clearly something is fundamentally different. The

difference is that ETF short-sellers including hedge funds, dealers

and arbitragers are confident they can always create the shares needed

to cover, so they see less risk of being squeezed.

DG: But in a traditional short-selling situation, you typically have to borrow the shares before you can short them.

short-sold again down a daisy chain. That’s how you get these

involves new buyers coming in without the shares being created at all,

and that’s the fundamental asymmetry in the short-selling that we’re

DG: Let’s get to that,

concern is that the huge short interest building up essentially leaves

the ETF as a fractionally reserved stock ownership system. If you have a

Redemptions have to flow through an authorized participant, which is

usually a broker or market-maker, and it’s only that institutional layer

it seems that it’s not so much the fund that might have a problem. The

fund is only liable for the shares it has issued. The risk seems to lie

AB: Right. Essentially you have just

that. You have quite a bit of counterparty risk here, because if you

think your shares can be redeemed and then the fund halts redemptions

because theyre running out of the underlying stocks, you’re stuck.

Normally ETF shares are redeemable through the authorized-participant

Now the big question is, in practice, would this happen?

It’s up to everyone to form their own conclusion, but interestingly the

first argument we heard when we began looking into ETFs was that this

redemption in a large ETF. But we have since learned that’s actually not

the case, because a giant redemption in IWM, one of the largest ETFs,

occurred in 2007.

Now we think that 2007, being one of the best

markets for equities since maybe the late 90s, was a pretty forgiving

time to test the crashworthiness of an ETF that runs into a massive,

unexpected redemption. But IWM was redeemed from millions of shares

outstanding down to something on the order of 150,000 shares, and in one

day, and that’s because somebody tried to crash the fund.

DG: Was that a really lousy fund, and somebody just said, Enough, I’m going to punish you guys and get out of it, or

Oh, no, no, IWM is one of the largest and most liquid ETFs in the

entire market. It’s the Russell 2000 iShares ETF. It is the poster child

of why ETFs are great. But even so, what’s interesting is that the

first argument we got from industry insiders was that our misgivings are

nonsense, growing out of some theoretical conversation about what might

DG: Lets stick with this potential

No. In fact, in one ETF, IWM again, short positions recently amounted

to 14 billion dollars. That’s not an enormous amount for the capital

markets, but it’s a pretty significant amount with respect to 2,000

So we think that if you

actually had a very sudden redemption run on IWM, there is a real

likelihood of a short squeeze occurring in the Russell 2000. We dont

expect that at any particular time, it’s just something that could

The short position in an ETF

of an ETF’s price with the fund’s NAV, which historically has been

extremely close, is totally dependent on an arbitrage mechanism. The

arbitrager can make money by continuously pushing the price of the ETF

toward its NAV. The question is. what NAV? What they mean by NAV is a

value per share outstanding of the fund’s underlying stocks. But of

DG: A lot of our readers have

money in GLD, which is the ETF that invests in physical gold. You’ve

looked at GLD, and it’s based upon the premise that as investors pour

money in, the operators of GLD turn around and buy physical gold and

store it. And likewise with redemptions, they just sell the gold. My

AB: The short position in GLD

isn’t nearly as large as it is for some equity funds but we have

looked at GLD, and it has the same structural issues, just to a lesser

extent, at least for now. The short interest in GLD has fluctuated

shares short, it is roughly 95% fractionally reserved. So for all the

investors who think they own the underlying physical gold, the fund

actually has 95% of it in the vaults.

But GLD does not have to

stay at 95% fractionally reserved. If there were a massive wave of

short-selling in GLD, you could end up with a very significant

fractional-reserve situation. If that were followed by heavy

redemptions, you’d have the same kind of problem I described earlier

not enough gold to redeem all the shares.

DG: Could they just say, From here on, we’re not issuing any more shares? Would that stop the short-selling?

dont necessarily have an immediate problem. It depends on the market

conditions and the level of panic. You certainly would have a ballooning

You know, one of the big risks, by the way, that no one has really

DG: Knowing what you do, I

mean, obviously you deal on an institutional level with your

money-management firm, do you own ETFs personally?

AB: We do not. We do not own any ETFs either personally or on behalf of the funds we manage.

DG: Is it because of the research youve done or just because it’s not what you guys do?

would say it’s primarily because it’s not part of our strategy, but

obviously we did the research because we were interested in

understanding the product better.

DG: So, any advice for readers? Is there a short interest over which a person should be concerned about his holdings?

Well, I dont know if I could set a threshold, but I would certainly

investors alike are aware of the counterparty risks that are hidden in

One ETF recently launched in the U.S. is PEK,

It is illegal for most foreign

investors except a few licensed global institutions to buy A shares

on Shanghai or Shenzhen, China’s two mainland stock markets, and Market

Vectors is not one of the exceptions. So instead of owning A shares, the

means to be short PEK in the first place, since it has historically been

illegal to be short A shares in China at all.

In essence, ETFs

are being used to package and securitize products that are at best

poorly understood and in some cases are used to circumvent securities

regulations. An example closer to home is when the SEC briefly banned

short-selling of essentially all financial stocks in 2008. The

financial-sector ETFs were not on the list, so many hedge funds kept

right on shorting financials using those ETFs.

DG: Certainly a lot to think about here. Any other questions I forgot to ask about, but that I should have?