7 ms·

The ETF Files: How the U.S. government inadvertently launched a $3T industry

123 points by tinkerrr 11y ago

TerryADavis 11y ago
space Aliens? The CIA has space aliens. My parents are CIA. God says... rheostat hang transfusion's brilliance heartened spiking injects seminary's hardens annuals ill heretical schizophrenia's sheltering Mills inconstancy's Mackenzie rationalized weakened consecrates repulsive stevedore Leakey Cantor smooch retribution rows outsizes Florentine artiste hooligans screening's The woman at the dollar store was clarvoyant. I had taken a shit and shit was on my mind, avoiding hand contact. Don't worry I washed them, but the thought was fresh. God helps by giving clues. God says... lichen armlet topple shampoo's spoonbill's transverses hydroplaning materialist's interject Librium's mishmash vermin donor potbelly Dodge samovar inspectors metaphorically theism overruled effusive newscaster Jan's citron's insectivore honks Velcro's paddock finesse's Antoine gardener solicit
Amorymeltzer 11y ago
Caught this story this morning on Bloomberg's Odd Lots podcast[1], it's a great story. The thread that stands out most to me (and to the hosts) is that here's a person who looks at an 840-page government report, reads it in-depth, and creates an industry. That's a feel-good outcome, of hard work others aren't willing to do. In a coincidence, perhaps, Planet Money's latest episode[2] dealt with Warren Buffet's bet on an ETF over hedge funds. 1: http://www.bloomberg.com/news/articles/2016-03-07/odd-lots-how-an-obscure-government-report-launched-a-3-trillion-industry http://www.bloomberg.com/news/articles/2016-03-07/odd-lots-h... 2: http://www.npr.org/sections/money/2016/03/04/469247400/episode-688-brilliant-vs-boring http://www.npr.org/sections/money/2016/03/04/469247400/episo...
- sparky_z 11y ago
  To be clear, the Warren Buffet bet was about index funds. Not all ETFs track index funds, and even the ones that do aren't necessary. You can just buy into the funds directly.
  - Amorymeltzer 11y ago
    Indeed, although Buffet did bet on an ETF, which was the index fund SPY.
  - xyzzy4 11y ago
    You can make even more money in the long run if you use leverage to bet on the S&P 500. If you don't believe me, do the math out.
    - scottlocklin 11y ago
      I guess this is tautologically correct, but if you did a 2x levered punt on SPX in 2007, you'd have gone broke.
      - xyzzy4 11y ago
        That's not true if you sell stock to maintain a certain equity to debt ratio. If you use leverage in the S&P 500 then you have much a faster growth rate, so in the long term it's still better.
    - worik 11y ago
      Clearly you cannot do math. It all depends on market timing, and if you get that wrong you will go broke as quick as your leverage. If you can get that right, well you would not be posting here, you would own here....
    - jegutman 11y ago
      There's a funny story I read a while back about this play. If you did this for long enough eventually you'd be the biggest company in the S&P 500 (technically maybe not, but in practice very much so!).
  - anonymousDan 11y ago
    Can you clarify the difference between an index fund and an etf? I always thought they were synonymous.
- voguchv 11y ago
  What backwards Kafka-esque horror show do you live in to believe a 800+ page government report of red tape and regulations is a feel-good outcome. Some people really do prefer slavery over liberty.
  - Veratyr 11y ago
    Are you really arguing for deregulation of the financial industry in the name of 'liberty'? Lack of regulation leads to things like the global financial crisis.
    - eru 11y ago
      Read your sibling comments. voguchv is just trolling, and is not even complaining about regulation. He's complaining about a post mortem..
  - Amorymeltzer 11y ago
    Putting aside the flamebait of your comment, you must not have read the story. The government report was following the massive crash in 1988 and was essentially an autopsy of what happened. One little section fantasized that perhaps a basket of funds might have helped avoid the events leading up to the crash. No regulations, no red-tape, just a postmortem accounting of the crash and a possible proscription.
  - RockyMcNuts 11y ago
    Did you read TFA? Someone did an in-depth study of a market incident, noted a gap in the market, someone else filled the gap and made a successful product. They both presumably view it as a desirable outcome. Your aversion to it as a (hardly heavy-handed) government intervention is not really their problem. If the same guy had written a white paper and tweetstorm while employed as a VC or investment banker or economics professor it wouldn't exactly be the difference between liberty and slavery.
- gcb0 11y ago
  not really. he built index funds just like before. he was just the first one to afford enough lawyers to launch a product that would be shut down by regulators because of 800 page conflicting regulations
hendzen 11y ago
That component-index arbitrage is what funds most OCaml development [0]. [0] - https://www.janestreet.com/what-we-do/etfs/ https://www.janestreet.com/what-we-do/etfs/
minimax 11y ago
One big factor in the success of these ETFs is automation (aka HFT). You don't get SPY quoted in size at a penny spread without the massive investments in research and technology on the part of the ETF market makers.
- emcq 11y ago
  Isn't the big allure of ETFs that you buy and hold for long time periods betting on the market rather than individual stocks and prices?
  - RandomBK 11y ago
    The value of the ETFs closely follow the value of the indices or securities that the fund was designed to track. It is therefore very important for the two securities to be as synchronized as possible, which is where (some forms of) HFT comes in.
    - emcq 11y ago
      Makes sense! You need to minimize tracking error on the underlying basket of assets, and the faster you are the less error you have.
      - eru 11y ago
        emcq is sort-of right, that for buy-and-hold investors a small tracking error is OK, as long as it does not accumulate over time. But once you have the nice deposit/receipt system set up to incentivise people to trade the tracking error away with arbitrage, you get a smaller and smaller tracking error for free.
        vostok 11y ago
        It is not obvious to me that the error would not accumulate. In fact, the opposite becomes somewhat clear if one looks at similar products that differ mainly in their lack of an arbitrage mechanism.
stygiansonic 11y ago
Aside: The article mentions the "portfolio insurance" strategy and "program trading" as causes of the October 1987 crash. Basically, the portfolio insurance strategy was common in the 1980's and was typically implemented through program trading. Portfolio insurance basically replicates a put option against some index, typically using index futures. The idea is that if you can't buy a put option against something, you can replicate it by creating a short position but you have adjust the size of the short position as the underlying price changes, aka a "dynamic hedge". Since the delta of a put option decreases as the price of the underlying falls, you have to short more (up to a point) when the price falls. There's nothing inherently wrong with this strategy. However, if everyone (or a substantial portion of the market) is following this same strategy, it could be bad. This paper [1] reviews the commonly-point-to reasons for the October 1987 crash, and talks about program trading and the portfolio insurance strategy as potential causes, but also indicates that there were other issues at play. This other paper [2] looks at what happens when everyone, or substantially everyone, is following the same or similar strategy when it comes to portfolio management and/or trading strategies. 1. http://www.federalreserve.gov/pubs/feds/2007/200713/200713pap.pdf http://www.federalreserve.gov/pubs/feds/2007/200713/200713pa... 2. http://docs.lhpedersen.com/EveryoneRunsForExit.pdf http://docs.lhpedersen.com/EveryoneRunsForExit.pdf
- digi_owl 11y ago
  > However, if everyone (or a substantial portion of the market) is following this same strategy, it could be bad. Monoculture comes to mind...
chiph 11y ago
I'm still skeptical of ETFs as I see them as being a derivative product - not trading the original shares, but tickets representing them. So I see the same dangers/risks with them as with mortgage-backed securities. While I may be acting like an old fuddy-duddy, there is this: >Of the 1,278 securities halted for trading, 80 percent involved ETFs, according to the SEC.
- mafribe 11y ago
  not trading the original shares, That depends on the type of ETF. As far as I understand a "Physical ETF" does hold the securities of the index it follows. In contrast, "Synthetic ETFs" track an index using swaps and collateral.
  - chiph 11y ago
    I assume they disclose what type they are? Also, any idea what the ratio of synthetic ETFs to physical ETFs may be? If it's low, it's not a potential market problem.
    - mafribe 11y ago
      The ETFs I looked at do disclose this. I guess it's a legal requirement, since it affects risk structure. No idea about the ratio.
  - nkd 11y ago
    It's worth noticing many "Physical ETF" lend the securities they hold, in order to increase the ETF performance.
- Jb6 11y ago
  The difference is in the leverage. MBS blew up the economy because the banks betting on them were very highly leveraged and had more obligations than they could realistically pay out. An ETF is more akin to a share of stock in a company. The worst it can do is go to 0 and lose all value. It won't result in a 30x loss like a derivative would.
- 11y ago
fitzwatermellow 11y ago
Good read! And timely as well, as it comes on the heels of the next big thing, the launch of the ETMF: First ETMF by Eaton Vance Hits the Market http://www.nasdaq.com/article/first-etmf-by-eaton-vance-hits-the-market-cm587566 http://www.nasdaq.com/article/first-etmf-by-eaton-vance-hits...
thinkcontext 11y ago
"a $3T industry" Not. $3T is the value of the assets held by the funds, the value of the industry is the expense fees. Its probably lower than that, if ETFs didn't exist some portion of that $3T would instead be held in mutual funds.
qaq 11y ago
If one likes conspiracy theories one could argue it was deliberate move to concentrate voting rights. Considering that 4 entities now control voting rights in majority of public US companies one could argue it worked.

123 points by tinkerrr 11y ago

space Aliens? The CIA has space aliens. My parents are CIA. God says... rheostat hang transfusion's brilliance heartened spiking injects seminary's hardens annuals ill heretical schizophrenia's sheltering Mills inconstancy's Mackenzie rationalized weakened consecrates repulsive stevedore Leakey Cantor smooch retribution rows outsizes Florentine artiste hooligans screening's The woman at the dollar store was clarvoyant. I had taken a shit and shit was on my mind, avoiding hand contact. Don't worry I washed them, but the thought was fresh. God helps by giving clues. God says... lichen armlet topple shampoo's spoonbill's transverses hydroplaning materialist's interject Librium's mishmash vermin donor potbelly Dodge samovar inspectors metaphorically theism overruled effusive newscaster Jan's citron's insectivore honks Velcro's paddock finesse's Antoine gardener solicit

Amorymeltzer 11y ago

Caught this story this morning on Bloomberg's Odd Lots podcast[1], it's a great story. The thread that stands out most to me (and to the hosts) is that here's a person who looks at an 840-page government report, reads it in-depth, and creates an industry. That's a feel-good outcome, of hard work others aren't willing to do. In a coincidence, perhaps, Planet Money's latest episode[2] dealt with Warren Buffet's bet on an ETF over hedge funds. 1: http://www.bloomberg.com/news/articles/2016-03-07/odd-lots-how-an-obscure-government-report-launched-a-3-trillion-industry http://www.bloomberg.com/news/articles/2016-03-07/odd-lots-h... 2: http://www.npr.org/sections/money/2016/03/04/469247400/episode-688-brilliant-vs-boring http://www.npr.org/sections/money/2016/03/04/469247400/episo...

sparky_z 11y ago
To be clear, the Warren Buffet bet was about index funds. Not all ETFs track index funds, and even the ones that do aren't necessary. You can just buy into the funds directly.
- Amorymeltzer 11y ago
  Indeed, although Buffet did bet on an ETF, which was the index fund SPY.
- xyzzy4 11y ago
  You can make even more money in the long run if you use leverage to bet on the S&P 500. If you don't believe me, do the math out.
  - scottlocklin 11y ago
    I guess this is tautologically correct, but if you did a 2x levered punt on SPX in 2007, you'd have gone broke.
    - xyzzy4 11y ago
      That's not true if you sell stock to maintain a certain equity to debt ratio. If you use leverage in the S&P 500 then you have much a faster growth rate, so in the long term it's still better.
  - worik 11y ago
    Clearly you cannot do math. It all depends on market timing, and if you get that wrong you will go broke as quick as your leverage. If you can get that right, well you would not be posting here, you would own here....
  - jegutman 11y ago
    There's a funny story I read a while back about this play. If you did this for long enough eventually you'd be the biggest company in the S&P 500 (technically maybe not, but in practice very much so!).
- anonymousDan 11y ago
  Can you clarify the difference between an index fund and an etf? I always thought they were synonymous.
voguchv 11y ago
What backwards Kafka-esque horror show do you live in to believe a 800+ page government report of red tape and regulations is a feel-good outcome. Some people really do prefer slavery over liberty.
- Veratyr 11y ago
  Are you really arguing for deregulation of the financial industry in the name of 'liberty'? Lack of regulation leads to things like the global financial crisis.
  - eru 11y ago
    Read your sibling comments. voguchv is just trolling, and is not even complaining about regulation. He's complaining about a post mortem..
- Amorymeltzer 11y ago
  Putting aside the flamebait of your comment, you must not have read the story. The government report was following the massive crash in 1988 and was essentially an autopsy of what happened. One little section fantasized that perhaps a basket of funds might have helped avoid the events leading up to the crash. No regulations, no red-tape, just a postmortem accounting of the crash and a possible proscription.
- RockyMcNuts 11y ago
  Did you read TFA? Someone did an in-depth study of a market incident, noted a gap in the market, someone else filled the gap and made a successful product. They both presumably view it as a desirable outcome. Your aversion to it as a (hardly heavy-handed) government intervention is not really their problem. If the same guy had written a white paper and tweetstorm while employed as a VC or investment banker or economics professor it wouldn't exactly be the difference between liberty and slavery.
gcb0 11y ago
not really. he built index funds just like before. he was just the first one to afford enough lawyers to launch a product that would be shut down by regulators because of 800 page conflicting regulations

hendzen 11y ago

That component-index arbitrage is what funds most OCaml development [0]. [0] - https://www.janestreet.com/what-we-do/etfs/ https://www.janestreet.com/what-we-do/etfs/

minimax 11y ago

One big factor in the success of these ETFs is automation (aka HFT). You don't get SPY quoted in size at a penny spread without the massive investments in research and technology on the part of the ETF market makers.

emcq 11y ago
Isn't the big allure of ETFs that you buy and hold for long time periods betting on the market rather than individual stocks and prices?
- RandomBK 11y ago
  The value of the ETFs closely follow the value of the indices or securities that the fund was designed to track. It is therefore very important for the two securities to be as synchronized as possible, which is where (some forms of) HFT comes in.
  - emcq 11y ago
    Makes sense! You need to minimize tracking error on the underlying basket of assets, and the faster you are the less error you have.
    - eru 11y ago
      emcq is sort-of right, that for buy-and-hold investors a small tracking error is OK, as long as it does not accumulate over time. But once you have the nice deposit/receipt system set up to incentivise people to trade the tracking error away with arbitrage, you get a smaller and smaller tracking error for free.
      - vostok 11y ago
        It is not obvious to me that the error would not accumulate. In fact, the opposite becomes somewhat clear if one looks at similar products that differ mainly in their lack of an arbitrage mechanism.

stygiansonic 11y ago

Aside: The article mentions the "portfolio insurance" strategy and "program trading" as causes of the October 1987 crash. Basically, the portfolio insurance strategy was common in the 1980's and was typically implemented through program trading. Portfolio insurance basically replicates a put option against some index, typically using index futures. The idea is that if you can't buy a put option against something, you can replicate it by creating a short position but you have adjust the size of the short position as the underlying price changes, aka a "dynamic hedge". Since the delta of a put option decreases as the price of the underlying falls, you have to short more (up to a point) when the price falls. There's nothing inherently wrong with this strategy. However, if everyone (or a substantial portion of the market) is following this same strategy, it could be bad. This paper [1] reviews the commonly-point-to reasons for the October 1987 crash, and talks about program trading and the portfolio insurance strategy as potential causes, but also indicates that there were other issues at play. This other paper [2] looks at what happens when everyone, or substantially everyone, is following the same or similar strategy when it comes to portfolio management and/or trading strategies. 1. http://www.federalreserve.gov/pubs/feds/2007/200713/200713pap.pdf http://www.federalreserve.gov/pubs/feds/2007/200713/200713pa... 2. http://docs.lhpedersen.com/EveryoneRunsForExit.pdf http://docs.lhpedersen.com/EveryoneRunsForExit.pdf

digi_owl 11y ago
> However, if everyone (or a substantial portion of the market) is following this same strategy, it could be bad. Monoculture comes to mind...

chiph 11y ago

I'm still skeptical of ETFs as I see them as being a derivative product - not trading the original shares, but tickets representing them. So I see the same dangers/risks with them as with mortgage-backed securities. While I may be acting like an old fuddy-duddy, there is this: >Of the 1,278 securities halted for trading, 80 percent involved ETFs, according to the SEC.

mafribe 11y ago
not trading the original shares, That depends on the type of ETF. As far as I understand a "Physical ETF" does hold the securities of the index it follows. In contrast, "Synthetic ETFs" track an index using swaps and collateral.
- chiph 11y ago
  I assume they disclose what type they are? Also, any idea what the ratio of synthetic ETFs to physical ETFs may be? If it's low, it's not a potential market problem.
  - mafribe 11y ago
    The ETFs I looked at do disclose this. I guess it's a legal requirement, since it affects risk structure. No idea about the ratio.
- nkd 11y ago
  It's worth noticing many "Physical ETF" lend the securities they hold, in order to increase the ETF performance.
Jb6 11y ago
The difference is in the leverage. MBS blew up the economy because the banks betting on them were very highly leveraged and had more obligations than they could realistically pay out. An ETF is more akin to a share of stock in a company. The worst it can do is go to 0 and lose all value. It won't result in a 30x loss like a derivative would.
11y ago

fitzwatermellow 11y ago

Good read! And timely as well, as it comes on the heels of the next big thing, the launch of the ETMF: First ETMF by Eaton Vance Hits the Market http://www.nasdaq.com/article/first-etmf-by-eaton-vance-hits-the-market-cm587566 http://www.nasdaq.com/article/first-etmf-by-eaton-vance-hits...

thinkcontext 11y ago

"a $3T industry" Not. $3T is the value of the assets held by the funds, the value of the industry is the expense fees. Its probably lower than that, if ETFs didn't exist some portion of that $3T would instead be held in mutual funds.

qaq 11y ago

If one likes conspiracy theories one could argue it was deliberate move to concentrate voting rights. Considering that 4 entities now control voting rights in majority of public US companies one could argue it worked.