Should ETFs be allowed to include illiquid stocks?

By Felix Salmon
August 23, 2010
Harold Bradley, the CIO of the Kauffman foundation. He's something of an expert on high-frequency trading, quantitative strategies, and the like, and he raised an interesting question: why isn't the SEC banning ETFs which include small, illiquid stocks?

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I had a fascinating conversation on Friday with Harold Bradley, the CIO of the Kauffman foundation. He’s something of an expert on high-frequency trading, quantitative strategies, and the like, and he raised an interesting question: why isn’t the SEC banning ETFs which include small, illiquid stocks?

The question arises in the context of a stock market which is demonstrating more lockstep than ever: stocks are ever more correlated with each other, and instead of broad indices aggregating lots of different moves in different directions, as they did in the past, increasingly it’s the other way round, and stocks just move up or down depending on what the broader market is doing.

The rise of ETFs, especially in the day-trading space, surely exacerbates this syndrome. As ETFs tied to the S&P 500 get bought and sold in enormous volumes, arbitrageurs, many of them high-frequency automated algos, jump in to buy and sell the underlying stocks. It’s something that some people are worrying about, in that it cuts against the idea that the stock market is meant to allocate money efficiently between companies.

But when ETFs include small, illiquid stocks, the situation is even worse. Right now, the SEC says that 70% of securities in an ETF must be “actively traded”, or 50% if the ETF includes 200 or more securities. Which means that ETFs can have up to 50% illiquid stocks, which are relatively easy to manipulate.

Let’s say that you’re a predatory algo and you’re looking at activity in these ETFs with substantial holdings of small-cap stocks. When people are buying, you quickly load up on the underlyings; when they’re selling, you go short. Your activity will eat into the returns of the ETF, since you’re making it more expensive for the ETF to buy the stocks, and getting it a worse price when it sells. But more to the point, it will maximize volatility and room for manipulation in the underlying stocks, as well, while minimizing the useful information to be gleaned from their share price. If you buy straddles on these small companies — equity derivatives which pay off when volatility is high — then it’s easy to imagine how you can trigger payouts by playing around in the ETF space.

“We have a lithium battery ETF“, says Bradley. “These are designed for manipulation. What we’ve done is create derivative packages that give people the illusion they can trade small-cap stocks for cheap. Just because they’re in an ETF doesn’t make them liquid.”

I do think that a lot of investors like ETFs precisely because they have a certain degree of liquidity which is often missing from the underlying stocks. But I suspect that it’s even harder to create liquidity out of illiquidity than it is to create a triple-A credit rating out of junk-rated subprime securities. You might be able to credibly pretend that you’re doing it, but there’s a strong whiff of fakery as well.

Clearly the SEC is concerned about manipulation, since it put in place those 70% and 50% limits in the first place. But if limits should be put in place, why not set them at 100%? This is a genuine question, incidentally: I’m not saying that Bradley is right here. But I do think he’s asking an important question.

Update: Some very smart comments below, and be sure too to check out Izabella Kaminska, who does a great job of explaining the market mechanisms in English.

5 comments

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“It’s something that some people are worrying about, in that it cuts against the idea that the stock market is meant to allocate money efficiently between companies.”

It could reasonably be construed as an improvement in the rate at which information moves from the market for one stock to the market for another. Not all of the independence between stocks is efficient, surely.

My understanding of how ETFs work is different from yours (and I entirely allow the possibility that I’m wrong). My understanding is that the ETF never buys or sells shares of the underlying stocks; the sponsor simply stands ready to swap n_0 (newly created or destroyed) shares of the ETF for n_i shares of each underlying stock. If the ETF price ever gets out of line, some big financial entity that can operate on the scale of n_0 (a big number by the standards of retail shareholders) shares of the ETF will buy up the ETF or the constituents and perform the exchange; the scheme you outline would not make it “more expensive for the ETF to buy the stocks”, since the ETF never buys the stocks, but would keep the constituent shares better in line with the new price of the ETF, reducing the likelihood that a straight arbitrage would take place. This is just like stabilizing speculation under the gold standard that reduced the amount of gold that had to be shipped across the Atlantic, and this kind of behavior serves to mitigate the inefficiency caused by transaction costs.

Posted by dWj | Report as abusive

Felix – you seem massively confused here. dWj’s comment about touched on it, but your statement: “Your activity will eat into the returns of the ETF, since you’re making it more expensive for the ETF to buy the stocks, and getting it a worse price when it sells” is not correct.

If you buy an ETF, the ETF does not go out and buy any stocks at all. If you pay more than the “NAV” for an ETF, then an arbitrageur might short it to you while buying the underlying basket of stocks that compose the ETF at the same time. He’ll then take his basket of stocks and deliver them to the ETF trust, “creating” shares of the ETF to cover his short. Note that this is a GOOD thing, not a bad thing, as it enables you to buy the ETF cheaper than you otherwise would have had the arbitrageur not existed. email me if you want a deeper explanation of this process.

Posted by KidDynamite | Report as abusive

felix – for a deeper thought experiment, just consider this claim: ETFs composed of less liquid stocks should themselves be less liquid (the LIT etf you mention, for example, is relatively illiquid!). This is because arbs can’t source liquidity as easily in the underlying stocks, and thus can’t offer liquidity as easily in the ETF.

Posted by KidDynamite | Report as abusive

ETFs are 90% of the S&P 500′s volume these days

Posted by STORYBURNthere | Report as abusive

High speed electronic trading and dark liquidity pools will have three blindingly obvious consequences:
1. The small investor not hooked up to the hardware will be at a bigger and bigger disadvantage.
2. The manipulative directionalising of a sector will become ten times easier, and impossible to trace.
3. The stock markets will become further and further removed from the right situation – where bad stocks are seen to fail – to the wrong situation – where a certain amount of excrement can be mixed with the putty.

I’ve done a lot of preparatory investigation of this practice in the UK, and some on the US West Coast. It is obviously already being massively abused, and awaits only a whistleblower to grab the media’s attention.

As a trend, however, the electrification of the stock trading system is just another dimension of a global trend right now: for ordinary investors, bank customers, web users etc to become third-class customers increasingly remote from the actions of a greedy elite.

http://nbyslog.blogspot.com/2010/08/anal ysis-bizarre-public-offering-that.html

Posted by nbywardslog | Report as abusive