ETFs offer a window into the behavior and liquidity of an underlying asset class—but nothing more.
[This article previously appeared on our sister site, IndexUniverse.eu.]
Which financial innovation introduced greater tradability to a range of financial market assets, was acclaimed as representing the “democratisation of capital”, was widely adopted as a new technology and was held to have brought down companies’ cost of finance?
For the answer, read down a little further.
But first, a short digression. iShares, the world’s largest issuer of ETFs, recently published an open letter on its website. The letter appeared at the tail end of a bad month for ETFs (June 2013 witnessed the largest redemptions from the sector since early 2010).
In the view of iShares’ global head, Mark Wiedman, “more and more, ETFs are becoming the true market”.
ETFs increasingly allow investors to gauge the true market price for a particular investment exposure, Wiedman argues.
In the open letter he says that “in a rapidly moving market, the reported prices of individual underlying securities may become stale,” before concluding that “the ETF price can become the true price for that market, and the underlying assets may eventually catch up with any gap between the two (called a ‘premium’ or ‘discount’)."
According to iShares, the ETF is effectively taking the lead in pricing the stocks or bonds in the underlying index, not merely acting as a passive, “pass-through” vehicle to reflect the prices of the constituents.
You can see where iShares (and other ETF proponents who have made similar arguments) are coming from.
There’s ample evidence of ETFs in a sense “becoming” the market: from the huge volumes and wafer-thin dealing spreads of the SPDR S&P 500 fund, the most traded single security in the world, to the recent boom in junk bond funds, where you can trade in and out of the index basket (via an ETF) at a hundredth of the cost of dealing in the underlying bonds themselves.
iShares, it appears, judging by recent statements, has big ambitions for its ETFs to be seen as more than just tradeable index funds. The firm appears to want its funds to combat futures and other derivatives markets as well as to take on, to some extent, the role played by individual stocks.
All the same, Wiedman’s comments make me uneasy. They remind me of the point at which another financial innovation went wrong.
That new force in the financial markets was securitisation, a technique that gained the plaudits I mentioned in the opening paragraph. It was indeed hailed as a democratising force, one that enhanced the tradeability of previously illiquid assets and which brought down access costs to the financial markets. There’s an excellent short history of the topic on the Economist website.