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

Some might surprise why iconic lively money manager Warren Buffett likes to tell other folks to buy cheap index price range to take part within the stock market.

His recommendation has to do with minimization of prices, which adds so much to performance over the years. Still, I've by no means heard him say the rest about buying a lower-cost index alternate traded fund (ETF), which is a passive investing automobile similar to an index fund. An ETF supplies day by day liquidity, whereas index mutual price range best get their web asset price (NAV) updated after the shut of trading.

While on the surface ETFs might look awesome to index price range because of this intraday pricing — and, hence, they've noticed massive enlargement, to the tune of $3.6 trillion in property within the U.S. and much larger globally (see chart) — under the skin, this intraday pricing “benefit” of ETFs can get truly unsightly.

There is not any hard-and-fast rule in keeping apart the great and dangerous ETFs, especially with new issues coming out each and every month, however after spending 20 years in this fascinating international of finance in quite a lot of roles, I can let you know from experience that no more than a 3rd of ETFs fall into the “OK” category. The rest are like a shell-game rip-off. (For more in this issue, see “This is what occurs when Skynet from ‘Terminator’ takes over the stock market.”) And, no, market regulators have now not accomplished just about enough to handle those problems, which are rising larger by way of the day.

High-frequency trading

Michael Lewis, who was a best-selling creator together with his tell-all books concerning the international of finance, gave a “60 Minutes” interview when selling his ebook 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 spoke back: “Stock market’s rigged. The United States stock market, the most iconic stock market in international capitalism, is rigged.” (The video is to be had on Youtube.) While Lewis’ ebook covers HFT, the entire issues defined in this article stem from that more or less automated trading, as it's HFT that makes ETFs conceivable.

There are a large number of ways to “shave” nickels and dimes with bid-ask spreads, tracking errors and the like, so within the majority of circumstances the arbitrageurs are the ones that make the money at the expense of particular person buyers. As a rule of thumb, the more liquid the ETF is in the case of day by day volumes, the much more likely it's that tracking errors and bid-ask spread problems will be smaller, although extremely unstable 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’ drawback.”)

ETFs, ETPs and ETNs

I regularly get this question from purchasers: “What is an ETP, and what is the difference between an ETN and an ETF?” An alternate traded product (ETP) is an umbrella term for alternate traded price range (ETFs) and alternate traded notes (ETNs). While ETNs and ETFs might look an identical in the way in which that they are passive investing products that track indexes and supply intraday liquidity to buyers, they are basically different. An alternate traded word is a legal responsibility of the issuer and is technically debt this is designed to trace an index. It is a lot more of a black field than an alternate traded fund, which is technically a consider stuffed with property, whether they are stocks, bonds and even derivatives like futures contracts.

In many circumstances, ETNs tend to use more derivatives to make what is, in essence, unsecured debt track their index of choice, while ETFs might or would possibly not use derivatives, like futures. To make matters worse, there are leveraged ETPs where the tracking error and bid-ask spread issues have a tendency to be magnified merely due to the leverage factor. The want for ETNs arises from the desire of the issuer to nook the arbitrage market (as there's usually one arbitrageur within the face of the issuer) and as such earn more money that manner, where with ETFs there are more than one arbitrageurs and subsequently the facility to take advantage of discrepancies between the NAV and the market price of the ETF is usually smaller.

While I think it's extremely not likely for coverage makers to let any other systemically necessary firm like Lehman Brothers fail — are you following what is going on with Deutsche Bank DB, -2.41%  right now? — its chapter does illustrate the fundamental flaws of ETNs (read: unsecured debt). All of Lehman’s ETNs went to 0 as there was no buyer to be discovered for its ETN trade in the midst of the 2008 Wall Street crash.

Bid-ask spreads

As a rule of thumb, the smaller the day by day quantity and property in an ETP, the bigger the issues with bid-ask spread liquidity and tracking errors. It is beautiful transparent to me that many ETPs are being introduced in order that the issuers can milk unsuspecting buyers by way of bid-ask spread slippage and NAV arbitrage. It is sort of like a sparsely designed legal shell recreation, where automated trading transfers property from unsuspecting buyers in ETP products into the wallet of arbitrageurs. While legally now not a rip-off, it acts like a rip-off, where the goal isn't to lend a hand buyers however to hoover up their nickels and dimes at very immediate speeds.

An experienced trading department can deal with this shell recreation due to more sophisticated get entry to to market information by way of level-2 quotes, however particular person buyers who still have now not mastered “all or none” and “fill or kill” restrict orders — and dare I say still use “market orders”? — are the roadkill that keeps piling on the facet of the HFT-ETF freeway. (For more, see our “ETF Sharks” document.)

A ‘dangerous’ ETF

While it is not unheard of for a closed-end fund to trade with a large premium or cut price to NAV due to the lack of arbitrage, it's in point of fact atypical to look huge premiums or reductions on an ETF out of doors of extremely unstable environments like August 2015 or February 2018. A case in point is the ETF MG Alternative Harvest ETF MJ, -1.51%  in December 2017, which is advertised with the intention to put money into legal marijuana.

This ETF didn't at all times trade under the ticker “MJ” on the Amex. The previous ticker was “MJX.” When we asked certainly one of our industry sources why this ETF lately experienced an enormous NAV premium of 24.06% (see proof) with no specific market surprise tournament on Dec. 29, 2017, here's what he mentioned:

“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 consider, so this might fall under the first category, where NAVs drift from the underlying from provide/call for issues. Naturally, market makers are professionals in their products, so they are going to use this to their benefit to widen bid and offer spreads. Remember, the wider the spread that they can probably trade at, as opposed to what they consider it's worth, this represents their margin. Their passion is to stay the spread as large as they can with out pricing themselves out of a trade, until in fact they don’t need it.”

In final, I wish to say that Michael Lewis is right: There are massive scams happening within the stock market right now. ETF industry issues are a subset of the bigger HFT drawback, however the regulators are asleep at the transfer. The best trail forward is for trading to be managed by way of experienced other folks, and now not computer systems which might be programmed to utilize millisecond advantages from specifically put in shorter fiber optic cables that connect New York with Chicago with the intention to “legally” front-run buyers.

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

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

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