5 ms·

ETFs: The next crash?

40 points by hardik 16y ago

lzw 16y ago
The blame may be pinned on ETFS if it happens, t the mechanism described in this article is really a regulatory construct that creates a type of short selling that is problematic. Maybe it might also exist in a free market, but it is protected by regulation now.
- borism 16y ago
  yeah, I don't think the blame actually lies with ETFs. It's naked short selling that is culprit again. I would not theoreticize whether it should be allowed in free market, the fact is it's illegal. However it might not be practical to demand all shorts to deliver or cover now, but I think if they're not willing then each and every one's financial positions should be assessed so that they have enough liquid assets to do so later.
  - BrentRitterbeck 16y ago
    Culprit of what? There's nothing wrong with the markets at the moment. They don't go straight up.
    - borism 16y ago
      culprit that is the topic of this discussion which is "ETFs: The next crash?" as far as I can tell? Have you read the article?
      - BrentRitterbeck 16y ago
        Yeah, I read the article. Naked short selling would have nothing to do with this. The parent ruled out ETFs and substituted naked short selling for the cause. You could view my post as highly sarcastic. EDIT: Maybe I should clarify further. The next crash will not be because of anything related to ETFs or any type of shorting. The next crash will be the result retail investors having unrealistic expectations about how fast the market will rise. The 1990s and mid 2000s set unrealistic expectations about how fast the market will rise. When retail investors are not pulling off double digit returns, they claim things are rigged and leave the market. This is what will drop the markets again. I say we're looking at another major downturn in about two years.
        borism 16y ago
        Naked short interest has nothing to do with naked short selling? Would you then like to explain what has anything to do with this? I find this issue highly important, so I wouldn't expect "highly sarcastic" comments of very high use. EDIT: the article is not about "The Next Crash". It's about the hidden risks associated with ETFs.
        BrentRitterbeck 16y ago
        I read the parent's comment differently.
        joe_the_user 16y ago
        The article explicitly says that EFT's are a way to achieve naked shorts. Whatever you think will be the next crash, naked shorts are key topic in the article.
      - deleted 16y ago
        [deleted]
  - mattmaroon 16y ago
    Well, the blame doesn't lie in ETFs per se. I mean, the people running the ETFs have done nothing dangerous or wrong. But the way ETF shares can be created allows people to naked short a much larger number of shares safely. So this would not happen with, say, Microsoft stock, but may with a large index ETF.
bcl 16y ago
This reinforces my belief that the 'market' is just one giant shell game. Invest your money in something tangible like making a product.
- bryanh 16y ago
  Have you thought about all the legitimate uses for a capital market? Say, issuing stock to fund a plant that will make a product? No one denies that investors will play equities for short term gain, but for every one of those there are more who are actually deriving true value from this 'market'.
- dschobel 16y ago
  What shell game? I can buy a share of Microsoft for ~$25 and then I get a vote in how the company is run and receive a percentage of the profits. Microsoft in turn gets to use the equity to build bigger and better things. Seems pretty fair to me.
  - mdda 16y ago
    It's not quite so simple. The $25 you spend on the share isn't used by Microsoft : It's used to pay to the seller of the share. Until Microsoft needs to issue more shares (or repurchase them), the value of the stock is not meaningful (to the company). Of course, people with stock options care about the value of the stock. In the same way, it's actually bad outcome for a company to have their stock jump up after the IPO : it means that the company missed the opportunity to raise even more money (for the same amount of dilution for existing holders).
  - bcl 16y ago
    http://www.fool.com/investing/general/2010/09/17/5-companies-that-doubled-earnings-while-their-stoc.aspx http://www.fool.com/investing/general/2010/09/17/5-companies... How's MSFT doing for you these days? "In 2004, Microsoft earned $0.75 a share. Over the past year, it pulled down $2.10 per share. That's 18.7% earnings growth per year. Extraordinary. Yet Microsoft shares trade lower today than they did for all of 2004. Dividends provided some return, but shareholders have essentially been handed a donut for a company that's blown the lights out on earnings."
fraserharris 16y ago
The second comment in the article is interesting. Basically, ETFs are open-ended funds - you can't run out of the ETF securities because you can always create more. So, if the naked short is called, and there are no ETF securities on the open market to buy, the shorter can have an 'authorized participant' create more ETF securities (see link). Note that this is a very different situation than a stock, where there is a fixed amount of the securities available, which can only be created by the company issuing more stock. See: http://en.wikipedia.org/wiki/Exchange-traded_fund http://en.wikipedia.org/wiki/Exchange-traded_fund
- borism 16y ago
  yes, but the naked short must have the liquidity and solvency to purchase the underlying securities needed to cover her naked short in ETF.
  - cynicalkane 16y ago
    Same as any other stock. No reason ETFs are in any particular danger.
    - joe_the_user 16y ago
      The difference between naked shorting and regular shorting is that with naked shorting you only need the liquidity later. And they find out ... you don't have the money! All "financial innovations" boil down to ways of gambling with other people's money. The brokerage that can do naked shorts in a conventional way are doing it (see LTCM) and the article claims that EFTs open up this club to a wider membership.
      - mattmaroon 16y ago
        Ha. Well, not all, but yeah that's definitely pretty popular.
      - cynicalkane 16y ago
        I have no idea what you're talking about, or why it's getting upvotes. Naked shorts are "gambling", but it's with your own money, not other peoples. Also, LCTM was not a brokerage. I have a feeling you're wrong about more things, but I'm not confident I can parse your last sentence with 100% accuracy.
mattmaroon 16y ago
Clearly naked shorting needs to be either banned entirely or, perhaps, regulated in such a way that the buyers realize what they're getting and who the counterparty is. The problem is that normal shorting is often maligned but a very valuable tool for correcting markets and hedging positions. There's a strong outcry against shorting from people who don't know better, and I think in response the very valid complaints against naked shorting get drowned out.
- steveplace 16y ago
  "Abusive" naked shorting is already prohibited by the SEC, the enforcement, however, is a little suspect.
  - mattmaroon 16y ago
    How is abusive defined?
known 16y ago
I can say Gold ETFs aren't going to crash anytime soon.
- mindslight 16y ago
  Seriously? I've been figuring that fictitious gold is the next bubble to pop. Physical gold is hard money; obligations to deliver gold are not.
  - known 16y ago
    99% of gold supplies are controlled outside stock markets
teyc 16y ago
I don't get it. The volume of shorts in the markets is a dynamic quantity right? In the absence of new transactions, these shorts would disappear when the shares are physically transferred. Therefore, the risk here is counterparty risk, but I don't see this risk as being peculiar to ETFs right? Furthermore, once you have settled and obtained ownership, the risk is gone right?
steveplace 16y ago
Structural risk in etfs will always be there as they are not pure holdings of the underlying. For example, USO is a heavily followed (and traded) oil fund. However, it deals mostly in near term derivatives contracts, and it will continually underperform over time if the futures further out in time are priced higher then the near term futures. Other etfs with this problem are UNG and VXX and a host of others. Structural risk in sector etfs are most likely not as high as what this article states. Any market inefficiencies would most likely be fixed by arbitrage, and arb firms may explain the large amount of shorts in XRT for example. One of the major risks I see down the road is if gold actually does become a bubble. The major etf everyone watches is GLD, which does deal in physical gold. If a bubble hits its peak and redemptions come in, they will have to sell off some of that gold, which would accelerate the selling, providing a positive feedback loop-- which is what we normally see when a bubble crashes. Of course, all the risks I just mentioned, as well as the risks shown in the article, are spelled out in each etf's prospectus, so this is nothing new.

40 points by hardik 16y ago

lzw 16y ago

The blame may be pinned on ETFS if it happens, t the mechanism described in this article is really a regulatory construct that creates a type of short selling that is problematic. Maybe it might also exist in a free market, but it is protected by regulation now.

borism 16y ago
yeah, I don't think the blame actually lies with ETFs. It's naked short selling that is culprit again. I would not theoreticize whether it should be allowed in free market, the fact is it's illegal. However it might not be practical to demand all shorts to deliver or cover now, but I think if they're not willing then each and every one's financial positions should be assessed so that they have enough liquid assets to do so later.
- BrentRitterbeck 16y ago
  Culprit of what? There's nothing wrong with the markets at the moment. They don't go straight up.
  - borism 16y ago
    culprit that is the topic of this discussion which is "ETFs: The next crash?" as far as I can tell? Have you read the article?
    - BrentRitterbeck 16y ago
      Yeah, I read the article. Naked short selling would have nothing to do with this. The parent ruled out ETFs and substituted naked short selling for the cause. You could view my post as highly sarcastic. EDIT: Maybe I should clarify further. The next crash will not be because of anything related to ETFs or any type of shorting. The next crash will be the result retail investors having unrealistic expectations about how fast the market will rise. The 1990s and mid 2000s set unrealistic expectations about how fast the market will rise. When retail investors are not pulling off double digit returns, they claim things are rigged and leave the market. This is what will drop the markets again. I say we're looking at another major downturn in about two years.
      - borism 16y ago
        Naked short interest has nothing to do with naked short selling? Would you then like to explain what has anything to do with this? I find this issue highly important, so I wouldn't expect "highly sarcastic" comments of very high use. EDIT: the article is not about "The Next Crash". It's about the hidden risks associated with ETFs.
        BrentRitterbeck 16y ago
        I read the parent's comment differently.
      - joe_the_user 16y ago
        The article explicitly says that EFT's are a way to achieve naked shorts. Whatever you think will be the next crash, naked shorts are key topic in the article.
    - deleted 16y ago
      [deleted]
- mattmaroon 16y ago
  Well, the blame doesn't lie in ETFs per se. I mean, the people running the ETFs have done nothing dangerous or wrong. But the way ETF shares can be created allows people to naked short a much larger number of shares safely. So this would not happen with, say, Microsoft stock, but may with a large index ETF.

bcl 16y ago

This reinforces my belief that the 'market' is just one giant shell game. Invest your money in something tangible like making a product.

bryanh 16y ago
Have you thought about all the legitimate uses for a capital market? Say, issuing stock to fund a plant that will make a product? No one denies that investors will play equities for short term gain, but for every one of those there are more who are actually deriving true value from this 'market'.
dschobel 16y ago
What shell game? I can buy a share of Microsoft for ~$25 and then I get a vote in how the company is run and receive a percentage of the profits. Microsoft in turn gets to use the equity to build bigger and better things. Seems pretty fair to me.
- mdda 16y ago
  It's not quite so simple. The $25 you spend on the share isn't used by Microsoft : It's used to pay to the seller of the share. Until Microsoft needs to issue more shares (or repurchase them), the value of the stock is not meaningful (to the company). Of course, people with stock options care about the value of the stock. In the same way, it's actually bad outcome for a company to have their stock jump up after the IPO : it means that the company missed the opportunity to raise even more money (for the same amount of dilution for existing holders).
- bcl 16y ago
  http://www.fool.com/investing/general/2010/09/17/5-companies-that-doubled-earnings-while-their-stoc.aspx http://www.fool.com/investing/general/2010/09/17/5-companies... How's MSFT doing for you these days? "In 2004, Microsoft earned $0.75 a share. Over the past year, it pulled down $2.10 per share. That's 18.7% earnings growth per year. Extraordinary. Yet Microsoft shares trade lower today than they did for all of 2004. Dividends provided some return, but shareholders have essentially been handed a donut for a company that's blown the lights out on earnings."

fraserharris 16y ago

The second comment in the article is interesting. Basically, ETFs are open-ended funds - you can't run out of the ETF securities because you can always create more. So, if the naked short is called, and there are no ETF securities on the open market to buy, the shorter can have an 'authorized participant' create more ETF securities (see link). Note that this is a very different situation than a stock, where there is a fixed amount of the securities available, which can only be created by the company issuing more stock. See: http://en.wikipedia.org/wiki/Exchange-traded_fund http://en.wikipedia.org/wiki/Exchange-traded_fund

borism 16y ago
yes, but the naked short must have the liquidity and solvency to purchase the underlying securities needed to cover her naked short in ETF.
- cynicalkane 16y ago
  Same as any other stock. No reason ETFs are in any particular danger.
  - joe_the_user 16y ago
    The difference between naked shorting and regular shorting is that with naked shorting you only need the liquidity later. And they find out ... you don't have the money! All "financial innovations" boil down to ways of gambling with other people's money. The brokerage that can do naked shorts in a conventional way are doing it (see LTCM) and the article claims that EFTs open up this club to a wider membership.
    - mattmaroon 16y ago
      Ha. Well, not all, but yeah that's definitely pretty popular.
    - cynicalkane 16y ago
      I have no idea what you're talking about, or why it's getting upvotes. Naked shorts are "gambling", but it's with your own money, not other peoples. Also, LCTM was not a brokerage. I have a feeling you're wrong about more things, but I'm not confident I can parse your last sentence with 100% accuracy.

mattmaroon 16y ago

Clearly naked shorting needs to be either banned entirely or, perhaps, regulated in such a way that the buyers realize what they're getting and who the counterparty is. The problem is that normal shorting is often maligned but a very valuable tool for correcting markets and hedging positions. There's a strong outcry against shorting from people who don't know better, and I think in response the very valid complaints against naked shorting get drowned out.

steveplace 16y ago
"Abusive" naked shorting is already prohibited by the SEC, the enforcement, however, is a little suspect.
- mattmaroon 16y ago
  How is abusive defined?

known 16y ago

I can say Gold ETFs aren't going to crash anytime soon.

mindslight 16y ago
Seriously? I've been figuring that fictitious gold is the next bubble to pop. Physical gold is hard money; obligations to deliver gold are not.
- known 16y ago
  99% of gold supplies are controlled outside stock markets

teyc 16y ago

I don't get it. The volume of shorts in the markets is a dynamic quantity right? In the absence of new transactions, these shorts would disappear when the shares are physically transferred. Therefore, the risk here is counterparty risk, but I don't see this risk as being peculiar to ETFs right? Furthermore, once you have settled and obtained ownership, the risk is gone right?

steveplace 16y ago

Structural risk in etfs will always be there as they are not pure holdings of the underlying. For example, USO is a heavily followed (and traded) oil fund. However, it deals mostly in near term derivatives contracts, and it will continually underperform over time if the futures further out in time are priced higher then the near term futures. Other etfs with this problem are UNG and VXX and a host of others. Structural risk in sector etfs are most likely not as high as what this article states. Any market inefficiencies would most likely be fixed by arbitrage, and arb firms may explain the large amount of shorts in XRT for example. One of the major risks I see down the road is if gold actually does become a bubble. The major etf everyone watches is GLD, which does deal in physical gold. If a bubble hits its peak and redemptions come in, they will have to sell off some of that gold, which would accelerate the selling, providing a positive feedback loop-- which is what we normally see when a bubble crashes. Of course, all the risks I just mentioned, as well as the risks shown in the article, are spelled out in each etf's prospectus, so this is nothing new.