This is how some ETFs are run like a shell-game scam

Some may wonder why iconic active money manager Warren Buffett likes to tell people to buy low-cost index funds to participate in the stock market.

His advice has to do with minimization of costs, which adds a lot to performance over time. Still, I have never heard him say anything about buying a lower-cost index exchange traded fund (ETF), which is a passive investing vehicle similar to an index fund. An ETF provides daily liquidity, whereas index mutual funds only get their net asset value (NAV) updated after the close of trading.

While on the surface ETFs may look superior to index funds because of this intraday pricing — and, hence, they have seen massive growth, to the tune of $3.6 trillion in assets in the U.S. and much bigger globally (see chart) — under the surface, this intraday pricing “advantage” of ETFs can get really ugly.

There is no hard-and-fast rule in separating the good and bad ETFs, especially with new issues coming out every month, but after spending 20 years in this fascinating world of finance in various roles, I can tell you from experience that no more than a third of ETFs fall into the “OK” category. The rest are like a shell-game scam. (For more on this issue, see “This is what happens when Skynet from ‘Terminator’ takes over the stock market.”) And, no, market regulators have not done nearly enough to address these problems, which are growing bigger by the day.

High-frequency trading

Michael Lewis, who became a best-selling author with his tell-all books about the world of finance, gave a “60 Minutes” interview when promoting his book on high-frequency trading (HFT) called “Flash Boys: A Wall Street Revolt.” At the onset, the interviewer asks him: “What’s the headline here?” Michael Lewis responded: “Stock market’s rigged. The United States stock market, the most iconic stock market in global capitalism, is rigged.” (The video is available on Youtube.) While Lewis’ book covers HFT, all the issues outlined in this article stem from that kind of computerized trading, as it is HFT that makes ETFs possible.

There are numerous ways to “shave” nickels and dimes with bid-ask spreads, tracking errors and the like, so in the majority of cases the arbitrageurs are the ones that make the money at the expense of individual investors. As a rule of thumb, the more liquid the ETF is when it comes to daily volumes, the more likely it is that tracking errors and bid-ask spread problems will be smaller, even though highly volatile market environments — like those in August 2015 — showed that even liquid ETFs can have some very serious problems. (See MarketWatch: “ETFs suffer from a ‘chessboard’ problem.”)

ETFs, ETPs and ETNs

I often get this question from clients: “What is an ETP, and what is the difference between an ETN and an ETF?” An exchange traded product (ETP) is an umbrella term for exchange traded funds (ETFs) and exchange traded notes (ETNs). While ETNs and ETFs may look similar in the way that they are passive investing products that track indexes and provide intraday liquidity to investors, they are fundamentally different. An exchange traded note is a liability of the issuer and is technically debt that is designed to track an index. It is much more of a black box than an exchange traded fund, which is technically a trust full of assets, whether they are stocks, bonds or even derivatives like futures contracts.

In many cases, ETNs tend to use more derivatives to make what is, in essence, unsecured debt track their index of choice, while ETFs may or may not use derivatives, like futures. To make matters worse, there are leveraged ETPs where the tracking error and bid-ask spread issues tend to be magnified simply due to the leverage factor. The need for ETNs arises from the desire of the issuer to corner the arbitrage market (as there is typically one arbitrageur in the face of the issuer) and as such make more money that way, where with ETFs there are multiple arbitrageurs and therefore the ability to profit from discrepancies between the NAV and the market price of the ETF is typically smaller.

While I think it is highly unlikely for policy makers to let another systemically important firm like Lehman Brothers fail — are you following what is going on with Deutsche Bank DB, -2.41%  right now? — its bankruptcy does illustrate the fundamental flaws of ETNs (read: unsecured debt). All of Lehman’s ETNs went to zero as there was no buyer to be found for its ETN business in the middle of the 2008 Wall Street crash.

Bid-ask spreads

As a rule of thumb, the smaller the daily volume and assets in an ETP, the bigger the problems with bid-ask spread liquidity and tracking errors. It is pretty clear to me that many ETPs are being launched so that the issuers can milk unsuspecting investors via bid-ask spread slippage and NAV arbitrage. It is almost like a carefully designed legal shell game, where computerized trading transfers assets from unsuspecting investors in ETP products into the pockets of arbitrageurs. While legally not a scam, it acts like a scam, where the goal is not to help investors but to hoover up their nickels and dimes at very fast speeds.

An experienced trading department can deal with this shell game due to more sophisticated access to market data via level-2 quotes, but individual investors who still have not mastered “all or none” and “fill or kill” limit orders — and dare I say still use “market orders”? — are the roadkill that keeps piling on the side of the HFT-ETF highway. (For more, see our “ETF Sharks” report.)

A ‘bad’ ETF

While it is not unheard of for a closed-end fund to trade with a large premium or discount to NAV due to the lack of arbitrage, it is truly bizarre to see large premiums or discounts on an ETF outside of extremely volatile environments like August 2015 or February 2018. A case in point is the ETF MG Alternative Harvest ETF MJ, -1.68%  in December 2017, which is marketed as a way to invest in legal marijuana.

This ETF did not always trade under the ticker “MJ” on the Amex. The previous ticker was “MJX.” When we asked one of our industry sources why this ETF recently experienced a massive NAV premium of 24.06% (see proof) with no particular market shock event on Dec. 29, 2017, here is what he said:

“In a case like MJX, the Marijuana ETF, the underlying basket of stocks are smaller, illiquid Canadian-listed equities. The ETF is more liquid than the stocks, I believe, so this would fall under the first category, where NAVs drift from the underlying from supply/demand issues. Naturally, market makers are experts in their products, so they will use this to their advantage to widen bid and offer spreads. Remember, the wider the spread that they can potentially trade at, versus what they believe it is worth, this represents their margin. Their interest is to keep the spread as wide as they can without pricing themselves out of a trade, unless of course they don’t want it.”

In closing, I would like to say that Michael Lewis is right: There are massive scams going on in the stock market right now. ETF industry issues are a subset of the larger HFT problem, but the regulators are asleep at the switch. The best path forward is for trading to be controlled by experienced people, and not computers that are programmed to utilize millisecond advantages from specifically installed shorter fiber optic cables that connect New York with Chicago in order to “legally” front-run investors.

Ivan Martchev is an investment strategist with institutional money manager Navellier and Associates. The opinions expressed are his own.

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