By David Galland
Casey Report

An interview with Dr. Andrew Bogan

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 CNBC's Strategy Session.

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, with a special focus on the potential risks that might arise should they 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.

Andrew Bogan: Yes. Shares in a traditional mutual fund, whether it's an index fund or has a managed portfolio, don't trade in the open market. If you want to own shares, you buy them from the fund. If you want to get rid of your shares, you sell them to the fund.

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 always 100% reserved, meaning that the securities it owns correspond exactly to the shares its investors own. If you want your capital back, the fund can deliver it to you either in kind or in cash, depending on market conditions.

That's not the case with an ETF. Shares in an ETF trade in the open market, which is where retail investors buy and sell them. An ETF also issues and redeems shares every day, like a mutual fund. But, unlike a mutual fund, it does so only through "authorized participants," which are brokers, market-makers and other institutions.

DG: Jumping right to the point, has there ever been a problem with an ETF?

AB: ETFs have operated pretty well historically, but the mechanics of share issuance and redemption also creates some unique differences that we believe may lead to unintended consequences.

There already have been a few problems with ETFs, some more significant than others. The Flash Crash on May 6 of last year showed some structural issues with ETFs and perhaps with our whole market system for equities as well. It's hard to decide where to draw the line, but a lot of securities departed from their perceived value during the Flash Crash by very large amounts. The reasons are still not completely understood, although the SEC has made a reasonable effort to understand what happened.

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?

AB: In that particular case, it was around the derivative contracts that underlay the fund, although that kind of arrangement is very common with European ETFs. Even equity index ETFs in Europe tend to be structured that way, and that's also not uncommon with a lot of the foreign stock ETFs as well – including some of those traded here in the United States.

I think it's a clear example where you have a counterparty risk wrapped inside the fund that could be very significant in bad circumstances.

DG: In the case of the Flash Crash, your research paper pointed out that even though ETFs represent only 11% of the listedsecurities in the U.S., 70% of the canceled trades during the Flash Crash involved ETFs. Is there an explanation for that?

AB: Some clarity is starting to emerge from work done by the SEC and others. But from our perspective, those statistics are quite alarming. There's no good reason 70% of canceled trades would be in ETFs while only 11% of listed securities are ETFs. And even though ETFs trade more actively, they don't represent 70% of all trading volume. So any way you look at it, they were badly overrepresented among the canceled trades, i.e., overrepresented among the most extremely off-priced trades.

From the perspective of financial theory, that makes absolutely no sense. ETFs are meant to be index-fund trackers. They’re meant to represent a whole basket of shares, and yet these very securities that are meant to be diversified actually fell more than their underlying stocks during the Flash Crash, more often and more deeply.

That's quite 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 haven’t really looked closely enough at what the unintended consequences of ETF issuance and redemption mechanics are, and what the realities are in stressful market conditions.

DG: At this point, more than half the American Stock Exchange's daily volume is ETFs, which is quite a number. These things have only been around for, what, less than 20 years. Yet from everything I've read, it seems they’re not very well understood, even by you guys. Which is saying something because you’ve spent a lot of time looking at them, and there are still blank spots in your knowledge about how they actually operate.

AB: Absolutely, and I think that's an important point. We understand the mechanics of how an equity trades and from where it derives its value and how it's priced in the market. The mechanics for mutual funds are well understood also. The challenge with ETFs is that the process of issuing and redeeming shares that also are trading is much more complicated than a lot of people want to talk about. It allows for some unintended consequences, particularly in connection with short-selling, which became an important factor only in the last decade.

DG: Let’s talk about the process of creating new shares. If I'm running an ETF that is designed to mimic the S&P 500 index and I have a lot of people who want to own my fund, I can simply issue new shares based upon the flow of stocks into my fund, right?

AB: Shares can be created at the end of any day if someone delivers a basket of underlying stocks to the ETF through an authorized participant. And shares that are not wanted in the marketplace can be redeemed in kind for the underlying stocks – or in some cases cash. That's all been carefully structured and works smoothly. The issue is what happens when short-selling dominates the trading.

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 don’t 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.

AB: Yes, and that's true here too. But if you look at the Securities Settlement Failure data, ETFs are very oddly overrepresented, so it does look like there is some short-selling that happens before the shares are borrowed. But that's a small matter. The problem is that there is no limit to the amount of short-selling you can theoretically do while still having borrowed the shares. It simply requires the same share to have been borrowed, short-sold, borrowed from the new owner and short-sold again down a daisy chain. That's how you get these arbitrarily large short interest figures.

The short-selling 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 most concerned about.

DG: Let's get to that, because you have retail investors, for lack of a better word, and you’ve got the hedge funds. I suppose they could both own the same fund, but for completely different reasons; a hedger to hedge another bet, and a retail investor to pursue a certain goal, but the net result is that the short interest is still way out of whack from what you'd expect to see in a traditional stock. I suspect this is something that most of the retail investors are unaware of. So, where is the potential for the ETFs to get into trouble?

AB: The trouble could come from a number of different angles.

One concern is that the huge short interest building up essentially leaves the ETF as a fractionally reserved stock ownership system. If you have a fund, for example, that is 500% net short, then for every one holder of an actual share there are five other investors who own IOUs for the shares. Their real shares have been lent out and short-sold to someone else – usually without the original owner's knowledge, unless they read and still remember the margin agreement they signed when they opened the account 10 years ago.

For the ETF itself, it means that the fund holds only 15% of the underlying securities implied by the gross number of fund shares that investors think they own. The other 85% isn't totally missing, it just isn't held by the fund.

Morningstar commented that the money is all there, it's just in hidden plumbing in the financial system, and we agree with that exactly. The question is, how many investors understood they were storing their money in the hidden plumbing?

DG: So walk us through what might happen if there were large-scale redemptions. Let's just say that for whatever reason, people decided this was the time to get out of a particular fund. How do things get unwound?

AB: Redemptions have to flow through an authorized participant, which is usually a broker or market-maker, and it's only that institutional layer that can actually redeem. If for some reason a significant portion, say, half or 80% or so, of the total fund ownership wanted to redeem and get the underlying stocks from the ETF through the authorized participant layer, you would fundamentally have a crisis in a fractional-reserve system.

The ETF could not deliver the underlying stocks to all the would-be redeemers. The investors who really owned just an IOU on shares that had been lent to short-sellers wouldn't have a direct claim on the fund, so their demand to redeem would force an unwinding of the short-sales.