Comments on: Should ETFs be allowed to include illiquid stocks? A slice of lime in the soda Sun, 26 Oct 2014 19:05:02 +0000 hourly 1 By: nbywardslog Tue, 24 Aug 2010 07:42:00 +0000 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. ysis-bizarre-public-offering-that.html

By: STORYBURNthere Tue, 24 Aug 2010 01:51:52 +0000 ETFs are 90% of the S&P 500’s volume these days

By: KidDynamite Mon, 23 Aug 2010 21:10:37 +0000 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.

By: KidDynamite Mon, 23 Aug 2010 20:55:06 +0000 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.

By: dWj Mon, 23 Aug 2010 20:40:39 +0000 “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.