The question that I have raised in 2007-2008 and Herb Greenberg of CNBC asks below is how big is too big. Put another way - when does the tail wag the dog? i.e. when do the size of the ETFs overwhelm the stocks? (a separate story on that topic can be found here) With an asleep at the wheel SEC the answer will be "we won't know until we hit the wall, something implodes, every regulator is surprised, and the last vestiges of Americana loses faith in the stock market." Sounds like the status quo - never be proactive, always be reactionary after the house is on fire; works in all aspects of our American system.
Aside that issue which is more interesting to me, Herb Greenberg cites an entirely different topic I was not thinking of that highlights a potential flaw in the construction of ETFs. Combined with their (in some cases) immense size and popularity we increasingly have the issue of counterparty risk. Some of these ETFs (since you can create unlimited 'shares') have multiples of shares short against the amount long. While (theoretically) impossible for this to happen (I am excluding naked short selling) in an individual stock - it is happening in the ETF world. So what happens if there is a "run" on the ETF? Answer? (crickets chirping) But don't worry - in between views of porn, I am sure someone at the SEC is looking at it... err...
(p.s. last I checked SPY ETF was 9% of all trading volume, it has now bumped up to 10%)
Video below - discussion begins at 2:30 mark
The question of whether an ETF can collapse is the focus of a fascinating new report by Bogan Associates, an under-the-radar investment firm in Boston.
The concern of the Bogan report, as well as other market participants I’ve been talking to, is that the complexity of exchange-traded funds and their increased use as trading vehicles by hedge funds can be quietly but quickly creating serious market risk.
At the heart of the matter is what stock ETFs really are: Derivatives with unlimited share creation prospects. Unlike regular mutual funds, which buy and sell stocks with the cash from investors, ETFs buy so-called “creation units” from participating institutions. Each creation unit represents 50,000 shares owned by an “authorized participant.”
The “unmitigated open interest” he’s referring to a startling figure in the Bogan report: That while the SPDR S&P Retail ETFhas about 17 million shares outstanding, it has around 97 million shares short. That’s right, more than 500 percent of the ETF is net short.
“This implies total gross ownership of XRT in the market of roughly 96 million shares,” says Andrew Bogan, who co-runs the firm with his father, Thomas, a former interim research director at State Street. “So the assets held by the ETF operator (State Street Research - no relation to State Street Global Partners) in this fund are about $680 million, while the implied ownership of all the long holders would be worth $3.9 billion.
In effect, he says, this amounts to a “fractional reserve stock ownership system” and a “shadow market caused by massive scale short-selling.”
The big question: Who will be left holding the bag? (Mark's answer: I vote for the taxpayer! That is always a winning answer in Cramerica) Retail investors? Prime brokers? Even Bogan and his co-authors can’t answer that; the data is that unavailable and the issue is that complex.
Many critics are concerned that ETFs have grown well beyond their original intention and have become a monster that will wreak havoc.