Felix Salmon

When Pimco’s Total Return ETF launched earlier this year, it was clear what the biggest risk was:

The inability of the PIMCO Total Return ETF to use derivatives will prevent a perfect correlation and affect performance. The size of that difference will be watched closely and will play a role in the format’s acceptance by investors.

Peter Lewis, executive director of liquid markets at Nomura Securities International in New York, said while some deviation will not have a big effect on the acceptance of active ETFs, a wide gulf would be a point of objection.

The total return ETF is supposed to mimic the performance of Bill Gross’s flagship Total Return Fund. And the bad news is that it has failed to do so, by an enormous margin: there’s a whopping 350bp gap between the two already, and that’s just performance since March 1. Oops.

But here’s where things get interesting: the Total Return ETF has actually outperformed its namesake fund, rising 7.7% during a period when the older fund rose just 4.2%. And suddenly the investors who were worried about basis risk don’t seem to be nearly as worried any more:

Bill Gross’s Total Return Exchange Traded Fund has doubled its assets in less than two months, as performance trumped that of the world’s largest mutual fund, whose strategy it mimics…

Pimco Total Return ETF (BOND) reached $1 billion in net assets on May 21. Because the ETF is still much smaller than the mutual fund version, it can snap up notes with the biggest potential returns.

This is worrying on three different levels. First of all, it shows that investors still haven’t learned one of the first lessons of financial markets, which is that anything which can outperform substantially is also at risk of underperforming substantially. If the ETF is doing much better than the bond fund it’s meant to mimic, that’s not some happy reason to pile in, it’s a big red flag.

Secondly, this shows that sophisticated, actively-managed ETFs simply can’t do what they’re designed to do. Pimco is deliberately vague on the question of whether the ETF is meant to replicate the larger fund, or whether it’s just meant to follow the same strategy. But either way, a 350bp difference between the two, in the space of just four months, is pretty definitive proof that they’re very different animals indeed.

And finally, it’s evidence that the $263 billion Total Return mutual fund is simply too big at this point. Here’s the theory:

“It’s very difficult to beat the market when you are the market,” said Bonnie Baha, head of global developed credit at Los Angeles-based DoubleLine Capital LP, which oversees $38 billion. “Any choices you make will have an outsized impact when you’re smaller and more nimble. It stands to reason that there will be more opportunities that you can take and fly below the radar”.

I’m not completely convinced: the Total Return Fund can move very fast, when Bill Gross is so inclined. On the other hand, while there are good reasons why you might want to be invested in a $2 billion fund rather than a $20 million fund, it’s much less clear why an investor is better off in a $200 billion fund than in a $2 billion fund. Economies of scale, at some point, become diseconomies of scale.

And then there’s the simple question of Bill Gross’s finite attention budget: if he’s picking out smaller opportunities for his baby ETF, does that mean that at the margin he’s neglecting his main charge?

On top of all that is the fact that it seems to be decidedly non-trivial to work out the difference in performance between the ETF and the main fund. On July 6, for instance, Yahoo Finance reported that the ETF was up 6.2% since March 1, while the Total Return Fund was up 3.2% — a difference of 300bp. The same day, Bloomberg had the same 3.2% return for the fund, but said the ETF was up 6.8%, for a difference of 360bp.

All of which says to me that it’s very early days to be investing in the young and decidedly untested asset class of actively-managed ETFs. Pimco’s big institutional clients, with their billions of dollars invested in the main Total Return Fund, certainly aren’t moving their money over to the ETF just yet. If and when they do, it might be time to revisit. But for the time being, it’s probably best to just observe BOND’s nascence from the sidelines. Like all babies, it’s pretty much impossible to tell how it’s going to grow up.

I’m sorry I missed Devin Riley’s excellent post when I was writing about ETFs on Friday. Here’s his chart:

What you’re seeing here is a y-axis ranking assets under management: the biggest funds are lower down. The x-axis ranks launch date: the earlier the fund launched, the further it is to the left. The correlation could hardly be more obvious. If you want to be a hugely successful ETF, by far the best thing you can do is to launch early.

Here’s Riley:

Launch rank explains up to 81 percent of an ETF’s rank in its segment. More to the point, in 71 percent of all segments, the first-mover had the most assets.

To me, that was surprising.

Given that ETF issuers compete fiercely on expense ratio, index tracking, and marketing materials to win investors, it’s a little disheartening to learn that so much of an ETF’s success is tied to its launch date.

This is surely good for consumers, at least so long as people continue to launch new ETFs. Because when they do so, they’re going to have to compete aggressively on fees, if only because that’s the only way that they’ll ever be able to gain any kind of market share. In turn, the new low-cost competitors will keep fees on the market leaders low and falling.

In theory, eventually, the supply of new ETFs will dry up, and the less successful competitors will drop out of the market. At that point, the market leaders might in theory be able to start raising their fees. But I’m not so worried about that: the best way to increase fee income is to keep your fees low and constant, while increasing your assets under management. Any hint of fees going up is only going to attract new competitors, or incentivize existing competitors to lower their own fees.

So for the time being it’s fine to just buy whatever the biggest ETF is in any given asset class, and sleep easily at night. There’s a small risk that in future you might end up invested in something suboptimal, but you’ll probably hear about it if that happens. Investing isn’t normally this easy, so let’s just celebrate the idea that this strategy seems to work so well, and concentrate entirely on asset allocation rather than spending lots of time second-guessing which of many ETFs to choose from.

Conceptually, it makes sense that ETFs would be a winner-takes-all phenomenon. Expenses rise much more slowly than assets, which means that the bigger a fund gets, the cheaper it can be. And given that ETFs compete first and foremost on expense ratio, money is likely to pour into the cheapest-and-biggest funds, which allows them to get even cheaper. And so on.

So this chart, from Lipper, comes as little surprise.

In many ETF categories, it turns out, one ETF has the lion’s share of the market — Vanguard in total stock market ETFs, Market Vectors in precious metals, iShares in TIPS and investment-grade bonds.

So one would expect that those big dominant funds would be significantly cheaper than their competition — that would explain their dominance. And, one would be right — if you just look at precious metals. But elsewhere, that’s not the case.

Among total stock market ETFs, the Vanguard VTI fund is extremely cheap, charging just 0.06%, but the Schwab US Broad Market ETF charges exactly the same, and has just 0.46% of the assets in the class.

The cheapest investment-grade bond ETF is the Vanguard Long-Term Corporate Bond ETF, with an expense ratio of 0.14% — but it has only 2.3% of the purple pie. The iShares is only 1bp more, but has 90% of the assets.

And when it comes to TIPS funds, all of the big ETFs — iShares, Pimco, and SPDR — charge the exact same 0.20%. But iShares gets nearly all the business.

Now we’re not talking, here, about the kind of small, illiquid ETFs which can easily underperform. All of these funds are big enough that, to a first approximation, they’re all as safe as each other.

But still, at the margin, a big ETF is always going to be safer than a smaller one. And I suspect that most of these funds have a first-mover advantage, and that their competitors might well be losing money in their attempt to stay competitive with the giants in the space.

Is there any reason, for an individual investor, to choose one of the smaller ETFs rather than the big ones here? I don’t think so. Big mutual funds can be lumbering and dangerous, but big ETFs just have that much more clout in things like the repo market. And all ETFs get front-run by algorithmic high-frequency traders in exactly the same way: I don’t think big ones suffer more on that front.

My feeling is that if you choose the big fund, the fees might come down as it gets bigger; if you choose something small like the Schwab broad market fund, by contrast, the fees might well go up if its managers give up trying to compete with Vanguard. So if you’re going to buy one of these ETFs, you might as well follow the crowd. This is one area where contrarian investing will likely get you nowhere.

Harold Bradley and Bob Litan made some very good points about ETFs in their Congressional testimony last week — testimony which Paul Amery today greets as “a mixed bag”. But it’s hard to argue with this:

We have enough history with financial innovations to at least raise questions when we see an innovation growing at very rapid rates. ETFs are no exception. We believe that these instruments may now be undermining the fundamental role of equities markets in pricing securities to ensure that capital is efficiently allocated to growing businesses. When individual common stocks increasingly behave as if they are derivatives of frequently traded and interlinked ETF baskets, then it is trading in the ETFs that is driving the prices of the underlying stocks rather than the other way around.

There’s a tragedy of the commons going on here: for any given individual investor, ETFs make a huge amount of sense. But if individual investors — and a lot of institutions, too — all pile into ETFs en masse, then stocks lose their price-discovery role, and large deleterious effects can start emerging.

For instance, one big reason to buy a market index rather than a handful of individual stocks is that the index provides diversification. But that diversification is disappearing as people pile into ETFs:

High co-movement of securities is not new, often occurring when markets reflect crowd panic or euphoria. What is new, however, is how ETFs decrease diversification benefits, with stocks and sectors worldwide moving together, even when there is no panic. Stocks move together today more than at any time in modern market history with recent data indicating that individual common stock prices that make up the S&P 500 index now move with the index 86% of the time.

Here’s one particularly striking chart:

This isn’t the S&P 500, which has even higher correlations. It’s just large-cap stocks. Which are all moving together in lockstep — much more than they were even in 1987, and more even than they were in the Great Depression.

Amery comments:

It’s common sense that the more investors buy and sell equities via index trackers like ETFs and futures, the higher you’d expect internal index correlations to be. And since ETFs have been growing in importance, the greater you’d expect their impact on index stocks’ co-movements to be.

Researchers at JP Morgan came to similar conclusions last year, arguing that high-frequency trading is also playing a role in boosting internal index correlations.

There’s nothing forcing investors, by the way, to purchase those index trackers where such herd effects are most prominent. You don’t have to buy the S&P 500—you could easily choose an index put together in different ways and featuring different stocks. Arguably, avoiding “overowned” indices should be near the top of a list of any investor’s priorities.

This I find a bit less convincing. As the above chart shows, there are very high co-movements even outside the S&P 500, it’d be hard to find any kind of broad stock index without a high correlation. And if you only get a small benefit in terms of extra diversification, then the costs, in terms of higher ETF fees for unusual instruments, are likely to be higher than the benefits from diversification.

That said, there are lots of people who make money from the huge amounts of cash sloshing into ETFs, and especially from the way in which the S&P 500 ETFs have to rebalance every time the index changes. And the more popular S&P 500 ETFs become, the more we’re all just funneling cash — some 30bp per year, it’s estimated — to those rebalancing arbs.

What is to be done? At the margin, Bradley and Litan’s idea that ETFs should have tighter circuit breakers than individual stocks is a good one. Amery reckons that “it’s important not to leave loopholes where trading in the ETF is stopped, but that in most of the underlying stocks can carry on” — but I don’t see that. If you want to keep on trading individual stocks, that’s fine — just stop the ETF driving their movement.

But fiddling around with circuit breakers won’t make any difference on a day-to-day basis. And cracking down on ETFs more generally risks throwing the baby out with the bathwater. My feeling is that the best thing to do here is simply adopt the kind of financial-transactions tax that the Europeans are talking about — a 0.1% Tobin tax on all ETF trades. That would drive away the day-traders and rebalancing-arbs from the ETF market, leaving it to the buy-and-hold investors that ETFs are very good for. It can’t do much harm, and it could well do quite a lot of good, from a systemic-risk perspective.

Kid Dynamite and The Analyst have taken issue with my post about levered ETFs. We’re all in agreement that they shouldn’t be held for a period of longer than 1 day. But their argument is basically that the SEC can’t and shouldn’t protect people from their own stupidity. Here’s the Analyst:

As should be extremely obvious at this point, understanding how these ETF’s work is not rocket science, and it does not take much time/effort to do. If you do a quick google search for “how do leveraged etfs work” returns a large number of posts, most of which answer the question with little ambiguity.

Let me put this as nicely as possible: You have to be self-defeatingly ignorant/naive/lazy to trade these things without learning about them. If you have an internet connection, you’d actually have to go out of your way not to pick-up some basic knowledge about how leveraged ETF’s work just by sheer happenstance. The information is EVERYWHERE, easy to find, and just as easy to understand for anyone capable of opening a brokerage account.

Except, if you go back a month to when KD last wrote about these things, you’ll find him linking to a column by Dave Kansas — the founding editor of thestreet.com, and about as veteran and admired a markets journalist as it’s possible to find. And he got it wrong, as the correction at the bottom of the column attests.

My point here is that if you want to find out how easy and obvious something is, you don’t first look for someone who understands it and then ask them whether understanding it is easy. Instead, you look at a broad audience of people who ought to understand it, and look to see what percentage of them actually do.

And if you look at the people who are investing in TBT, it’s clear that the vast majority of them do not understand how it works. For all that there are prominent disclaimers in the abbreviated summary prospectus about such things, those disclaimers are not preventing people from making long-term investments in a security which should never be held for longer than one day. They’re not working.

What worries me here is that we’re taking rules which apply to stocks and applying them to levered ETFs, even when levered ETFs are very different creatures from stocks. Stocks are permanent long-term stores of value — ownership stakes in something real in the world. Levered ETFs, by contrast, are pretty much guaranteed to go to zero eventually; the only question is how long they will take to get there. That’s not a problem for people who hold them on an intraday basis, as trading vehicles. But they trade on the stock exchange with a stock-like ticker symbol, and they look similar to unlevered ETFs which do things like replicate the S&P 500, and which really are long-term investments. So it’s easy to see where the confusion arises.

What I’m not getting from KD or the Analyst is any good reason why levered ETFs should exist. What purpose do they serve? If you want to make a leveraged bet on a certain asset, you can buy it or short it using borrowed money. These things are obviously harming a lot of people — the investors wielding billions of dollars who are holding them for long periods of times. Who are they benefiting? It seems to me that the cost of leveraged ETFs is greater than the benefit; that’s why I think the SEC should look into them.

It’s one thing allowing people to invest in individual stocks which can be highly risky investments — that’s fine, because there’s a strong social upside to allowing companies to raise capital on the stock market and allowing individuals to buy those stocks. But there’s no such social upside to levered ETFs, and if they disappeared tomorrow, anybody using them the right way could very easily put on the same trades just by using their margin account. So if there’s good reason to believe they’re causing harm, and no reason to believe they’re causing any good, why keep them?

TBT, the ProShares UltraShort 20+ Year US Treasury fund, is an ETF which returns double the daily decline in an index linked to long-dated government bonds. There are 173 million shares of TBT outstanding, which at a price of $35.65 apiece, means that more than $6 billion is tied up in TBT shares. But average daily volume is just 10.7 million shares — which means that the overwhelming majority of TBT shares are not traded on any given day.

The helpful bloggers at Symmetric Info have explained in great detail — here’s Part 1 and Part 2 — why this is bonkers. But suffice to say that no one should ever hold a leveraged ETF overnight. These things are intraday trading vehicles; they’re not medium-term or even short-term investments.

Given how many people are clearly Doing It Wrong when it comes to TBT, I think there’s a strong case for the SEC to step in here and take a very hard look at TBT in particular, and levered ETFs in general. If day-traders want to day-trade using ETFs, that’s fine — and they can bring their own leverage, if they’re so inclined. But ETFs with embedded leverage are clearly being bought by people who aren’t day-traders at all, and who have no business buying these securities. It’s the SEC’s job to protect those people. It should get on the case.

Sometimes, financial innovations seem like a good idea at the time, and it’s only later, after everything has gone pear-shaped, that it becomes clear we would have been much better off without them. Other times, financial innovations are clearly a bad idea from the get-go:

Factor Advisors, a New York-based asset management firm, announced today the launch of FactorShares, the first family of spread exchange traded funds (ETFs) that allow sophisticated investors to simultaneously hold both a bull and a bear position in one leveraged ETF…

FactorShares ETFs are capital efficient, targeting a daily leverage ratio of 4:1… FactorShares ETFs seek investment results for a single day only, not for longer periods.

Some investments, in things like hedge funds or private-equity funds, are considered so risky that you need to be qualified to buy them. Other investments — public stocks listed on the NYSE are a good example — can be bought by just about anybody. FactorShares, incredibly, are in the second category.

Needless to say, no one with an ounce of common sense should go anywhere near these things. Even if you’re convinced that bonds are going to outperform stocks, you should never touch FSA, the fund which gives you a 2x leveraged long position in Treasury bonds combined with a 2x leveraged short position in the S&P 500.

Just look at the official FactorShares FAQ if you want some of the reasons: the funds certainly should never be held overnight, and “may experience tracking error intra-day”; there’s “a compounding effect and tracking error”; the leverage fluctuates and “could be higher or lower than an approximately 4:1 leverage ratio”; there’s the inevitable Management Fee, of 0.75%; “other fees apply including brokerage commissions”; the shares “are not mutual funds or any other type of investment company within the meaning of the Investment Company Act of 1940, as amended, and are not subject to regulation thereunder”; the Managing Owner has been a member of the National Futures Association only since December 2009; the shares “may be adversely or favorably impacted by contango or backwardated markets”; you have to deal with a K-1 form for tax purposes at year-end; and I’m sure there’s lots of other stuff in the various prospectuses.

What confuses me is why the SEC, the NYSE, and other institutions who consider themselves to be protecting individual investors would ever allow these things to trade openly on the stock exchange in this manner. This isn’t a company raising equity capital so that it can invest in the real economy and grow and thrive. Instead, it’s a pointless, parasitical, negative-sum financial monstrosity which will probably make a modest sum for its sponsor and lose money, on average, for anybody who invests in it. It doesn’t even serve any legitimate hedging purpose.

ETFs looked like a good idea when they started replacing index funds. But the more that this kind of thing happens, the more of a bad name they’ll have. Let’s hope regulators wake up and shut this scheme down, and lots of similar ones too. People who buy these things aren’t “sophisticated investors”; they’re really not investors at all. If they want to gamble, there’s always Vegas.

How much are municipal bonds worth? There are lots of indices purporting to follow the market, but these days all the attention is on exchange-traded funds, which are plunging alarmingly. The volatility in municipal ETFs has already caused Vanguard to pull its plans to issue three more such funds, and the total amount of money in them seems to be falling fast:

Individual investors, who represent two-thirds of the market, withdrew more than $13bn from muni bond mutual and exchange traded funds in the last two months of 2010, an outflow that exceeded the sums they cashed out at the height of the financial crisis in 2008, Thomson Reuters data show.

When individual investors only owned specific bonds or muni mutual funds, outflows in the muni market were much less visible than they are today. With ETFs, outflows cause immediate and significant price drops, and that kind of volatility can in turn prompt even more selling from muni investors—who are, after all, risk-averse by their nature. Aaron Pressman writes:

Amid the turmoil, ETF investors have complained that some muni ETFs are not properly tracking their underlying market indexes. During the fourth quarter, for example, the share price of the $2 billion iShares S&P National AMT-Free Municipal Bond Fund, closed as much as 2.4 percent below the value of its assets, according to the iShares web site. The fund closed on Wednesday at a 0.5 percent discount.

Tracking problems arise because muni ETFs own only a portion of the thousands of bonds included in their underlying indexes. Fund managers try to create a representative sample of bonds but the technique sometimes goes astray when the market moves sharply.

But Dan Seymour has a different take, in a fascinating article about the increasing disconnect between municipal bond indices and the ETFs which try to track them, and comes to the conclusion that the ETFs actually do a much better job of price discovery than indices do—given that the indices, by their nature, comprise thousands of bonds which simply aren’t trading at all.

In other words, it’s not the fact that ETFs don’t own all bonds in the index which is the problem here, so much as the fact that the price of the index is a largely arbitrary measure, determined by implausible pricing services with the impossible job of evaluating the value of bonds that aren’t trading.

Financial markets often operate on the basis of a deliberate refusal to mark to market. In a crisis, all banks are insolvent on a mark-to-market basis, since there’s no real bid for that kind of quantity of loans. But they keep on servicing the loans, mark down the really bad ones, and often manage to come out the other side.

Similarly, in the municipal-bond market, in times of turmoil issuers simply stop issuing, and investors just keep hold of their bonds. Eventually, the market reopens, and things get back to normal; the official indices need not have moved very much at all in the interim. Many individual investors need be none the wiser; and as far as institutional investors are concerned, their best course of action is to simply sit tight, rather than try to sell into a bidless market.

The rise of the muni ETF changes all that. ETFs trade every day, and everybody knows their price. If bids dry up, as they’re doing right now, the price falls, in a very visible manner, to whatever the market-clearing level might be. In turn, that fall in price only serves to exacerbate the problem and the panic.

The observer effect, in physics, refers to the way in which a phenomenon is changed by the act of observing it. ETFs would love to be neutral reflections of the state of the muni market, but they’re not: they change the dynamics of the market dramatically, and not necessarily in a good way. Munis aren’t as safe, now, as they used to be, and the existence of ETFs is one reason why.

Have you ever wondered how big a stock needs to be before it can be efficiently arbitraged? The Fundometry blog has done an investigation along those lines and the answer would seem to be somewhere around $400 million in market cap.

Here’s the chart:

What you’re looking at here is four different ETFs, split into quintiles according to the size of their components. So the bar on the far left is the smallest 20% of stocks in the IWC microcap ETF, while the bar on the far right is the largest 20% of stocks in the S&P 500.

The y-axis, meanwhile, measures correlation: the degree to which each of the stocks in that quintile is correlated with the index as a whole.

Clearly correlation is very high these days across the market and in general stocks seem to have roughly a 70% correlation with their index. But the smallest stocks — the bottom quintile of the small caps and most of the microcaps — have lower correlation, probably because they’re so small and illiquid that it’s hard to arbitrage them against their respective index.

Microcap stocks, in this chart, are stocks with a capitalization between $50 million and $500 million, while small caps are capitalized between $300 million and $1 billion. So judging by the chart alone, I’m thinking that about $400 million is the point at which you can expect your stock to be arbitraged as a matter of course against its index.

This issue is related to Harold Bradley’s theories about manipulation of the relationship between microcap stocks and obscure ETFs: below about $400 million or so in market cap, it seems there’s a certain amount of inefficiency in the market and therefore room, in theory, for stocks to be manipulated. (Yes, there might be fundamental reasons why very small stocks have lower correlations than their larger brethren, but even so, the fact remains that these stocks are hard enough to trade that manipulation can be profitable.)

Are these findings, then, grist for Bradley’s mill? Do they demonstrate that ETFs shouldn’t include microcap stocks? No. A lot more work needs to be done on that front. But at least now we have an idea of where the manipulation is likely to be taking place, if it’s happening at all.

Herb Greenberg misreads the SEC flash-crash report, in an attempt to justify his silly claim that ETFs are derivatives. I agree with Herb that there are serious questions which should be asked about ETFs, especially ones which include small-cap stocks. You can’t turn an illiquid stock into a liquid stock just by throwing it into an ETF, and illiquidity is one of those things which goes hand-in-hand with volatility and attempts at price manipulation.

But that doesn’t mean that ETFs are derivatives. They’re not.

Herb quotes this bit of the SEC report:

The E-Mini and SPY are the two most active stock index instruments traded in the electronic futures and equity markets. Both are derivative products designed to track stocks in the S&P 500 Index, which in turn represents approximately 75% of the market capitalization of U.S.-listed equities.

There is a way in which this is true, but it’s best read as a slightly clumsy attempt to lump the E-Mini and the SPY together with some inartful phrasing.

The E-Mini is a derivative product by dint of being a derivative. It’s a futures contract, a zero-sum game, an instrument whose value at expiry is a wholly transparent function of the value of some other financial instrument.

The SPY, by contrast, is a derivative product only by dint of the fact that it’s a product — a security, not a derivative — which is derived from aggregating 500 different stocks. You couldn’t have the SPY without the S&P 500, so in that sense the SPY is derived from the S&P 500. But if you own shares of SPY, you have real wealth: real claims on real assets of 500 real companies in the real world.

Think about it this way. If all of the shares of SPY were to become vaporized tomorrow, then the S&P 500 itself would rise, since the total number of shares outstanding in the stock market would have fallen. Since the value of those 500 companies wouldn’t have changed, the value per share would be higher.

If all of the world’s E-Mini contracts were to become vaporized tomorrow, by contrast, then the effect on the S&P 500 would be de minimis. E-Mini contracts are side bets on the S&P 500: they’re not real-world claims on it.

What the E-Mini and the SPY have in common is that they’re both trading vehicles: both of them are used to make bets on the short-term direction of the S&P 500. That’s why, pace Greenberg, there’s so much short interest in SPY. If I want to short the S&P 500, I’ll borrow a few shares of SPY and then sell them in the market. Those shares will be bought by my counterparty, who will then turn around and lend them to someone else who wants to short the S&P. And so on and so forth: the same shares can end up being shorted many times by many different people.

But that doesn’t make them derivatives.

The distinction between securities and derivatives is a useful one. It’s always possible to argue that the value of any financial instrument is ultimately derived from the value of some other financial instrument: if you wanted to, you could probably come up with a colorable argument that senior unsecured bonds are derivatives of stock options. But in the real world, stocks aren’t derivatives, and ETFs are stocks. Derivatives, meanwhile, are something you call financial instruments you don’t like. Which is why occasionally people will erroneously say that CDOs, say, are derivatives. They’re not, any more than ETFs are.

Sam Mamudi has found a new way to slice mutual-fund data, and the results are very interesting: the flows aren’t just from domestic funds to international funds, as we can see from the monthly ICI data, but also from actively-managed mutual funds to index funds.

Since the end of 2005, actively run U.S. stock funds have seen net outflows every year, totaling $369 billion, while indexed counterparts — not including exchange-traded funds — have seen net inflows of $112 billion, according to fund-industry trade group the Investment Company Institute.

I went one further, and had a look at the ICI’s data on ETF flows. After all, to a first approximation, all ETFs are index funds rather than actively-managed.

Here’s how the numbers break down: total actively-managed mutual funds, both domestic and international, saw a net outflow of $37.7 billion in 2009, and of $24.1 billion in the first seven months of 2010. Meanwhile, passively-managed index funds saw a net inflow of $22.9 billion in 2009, and of $22.4 billion in 2010 so far. But get this: equity ETFs saw net inflows of $69.3 billion in 2009, and another $21.4 billion in 2010 to date.

Those numbers aren’t publicized by the ICI: I had to calculate them using their spreadsheet of monthly ETF data. But if you add it all together, there was a net inflow into equities of $60.5 billion in 2009, and another net inflow of $19.8 billion in the first seven months of 2010. People aren’t pulling their money out of the stock market, they’re just pulling their money out of actively-manged mutual funds in general, and actively-managed domestic mutual funds in particular.

If you look at growth rates, the numbers are even starker. Actively-managed domestic mutual funds saw an outflow of $44 billion in the first seven months of 2010, which was 1.45% of their total value. Equity ETFs, by contrast, saw an inflow of $21.4 billion, which was 3.12% of their total value. If you go back to 2009, the numbers are -2.07% and +10.78%, respectively. Yes, in 2009, the net inflow into equity ETFs (I’m not even including bond or commodity ETFs, here) was greater than 10% of their entire year-end value. Mutual funds, it’s fair to say, never see those kind of net inflows.

This shift is only just beginning. There’s more than $3 trillion invested in actively-managed domestic mutual funds, compared to just over $1 trillion in domestic index funds and domestic equity ETFs combined. On the international side, there’s $1.2 trillion in actively-managed mutual funds, compared to $218 billion in international ETFs, and just $97 billion in international indexed mutual funds.

So in terms of long-term investments, people are still massively overweight actively-managed strategies. But they’re sensibly rotating out of those funds, and into passive ETFs. As that trend continues, and I see no indication of it slowing down at all, one can only expect that correlations between different stocks will continue to rise. And as correlations rise, of course, it becomes increasingly difficult to justify an active strategy.

ICI chief economist Brian Reid says that “considering historical investor patterns for the last 20 years, we are currently seeing weaker investor demand for domestic equity mutual funds than those patterns would lead us to expect.” Too right we are. And there ain’t gonna be no mean-reversion, either. That $3 trillion is going to end up reallocated, sooner or later. And if your business model is based on managing domestic mutual funds and getting a steady flow of new investments, you’re not going to find life easy going forwards.

Paul Amery grabs this chart from a recent Deutsche Bank report:

The different lines are various ETFs, all of which seek to replicate the Euro Stoxx 50, which is the black line in the chart. Nearly all of them managed to outperform the index over the 20-month period in question, although if I were an investor in UBS’s ETF I’d certainly be asking questions. And it’s pretty clear that the degree of outperformance in many cases is a much larger component of total returns than is the headline expense ratio on the funds.

The chart shows post-fee performance, but it’s clear at a glance that it’s not lower fees which account for outperformance. Instead, explains Amery, a lot of it is dividend-tax jurisdiction shopping: funds will domicile themselves in countries with low dividend taxes, and/or lend out stocks over the dividend date to other funds in low-tax countries. For a fund like the Euro Stoxx 50 which comprises stocks from many different countries, the effects can be substantial.

None of which helps, particularly, in working out which fund to buy going forwards. Amery concludes:

It’s difficult to ascertain how the increased performance is actually being generated, why certain funds are doing better than others and what risks might be being incurred by the funds’ investors. In order to answer these questions in greater detail, investors would need to look more closely at securities lending activities, collateral policies and (for swap-based funds) the terms and conditions of the contracts between their ETF and the swap counterparty or counterparties. However, ETF managers’ disclosure of information in these areas is typically very limited indeed.

So, if you owned the iShares Euro Stoxx ETF, congratulations. If you owned the UBS version, commiserations. Going forwards, one can try to guess that iShares will continue to outperform. But that’s all it would be — a guess. We have no good reason to know why that might be the case.

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.

Is this the beginning of the end of ETFs as an asset class? Ian Salisbury has an important story this weekend, saying that the average ETF underperformed its benchmark by 125bp in 2009, and even the monster SPY underperformed by 19bp. That’s more than twice its total expense ratio.

The problem is that when ETFs become very big, they become lumbering and predictable, and nimble hedgies know exactly what they’re going to do and when they’re going to do it. As a result, the smart money front-runs the dumb ETFs, which end up underperforming, sometimes by a very large margin: the $40 billion iShares MSCI Emerging Markets Index ETF (EEM) lagged its benchmark by a whopping 6.7 percentage points in 2009. That’s over nine times its total expense ratio.

So while it’s a good idea to avoid small ETFs, and to avoid commodity-based ETFs as well, even the biggest, safest ETFs are beginning to look as though they might have reached a level of size and popularity that makes them suboptimal investments. That’s sad, if true, because they were great while they lasted, and because there’s no real alternative out there.

But the fact is that there’s no rule of investing saying that there is always an easy and obvious investment strategy for people of relatively modest wealth. Investing involves taking a large number of risks, some obvious, some less so. And if ETFs continue to underperform in 2010 to the same degree that they underperformed in 2009, their repo income notwithstanding, then ETFs — which looked for a while there as though they really might be that rarest of animals, a positive financial innovation — might well turn out to be a grave disappointment for millions of investors who thought they could make a handful of asset-allocation decisions and then sit back doing little if any more work from then on.

We’re not quite there yet: as Salisbury points out, EEM is still outperforming its benchmark since inception, and it ouperformed in 2008. And for long-term investors, a single year’s underperformance shouldn’t matter a great deal. But if this turns out to be something newly endemic to the asset class, there might well be no cure for the problem — and that’s worrying, given how popular ETFs have become.

Update: On the other hand, if EEM is good enough for the Harvard endowment to have $388 million in it…

Baptist values are going cheap! They’re only $25.27 per share, while Methodist values are $25.55, Lutheran values are $25.56, and Catholic values are $25.98 — the same price as general Christian values.

All these values are brought to you by the good people at FatihShares (“Invest with Conviction”). I’m seeing a long-Baptist, short-Catholic relative value play here; I’m just sad that I can’t get the video of this morning’s NYSE bell-ringing to work. I was hoping for something a bit more transcendant than usual.

(Via Crigger)