Kauffman Report On ETFs: The First Lie

November 08, 2010

With headlines sure to fly on Kauffman’s exhaustive 60-page diatribe against ETFs, it’s hard to know where to start poking holes. Let’s start with a whopper.

Let’s be clear—I haven’t had time to redline every error in the Kauffman report. But this one leapt off the page.

One of Kauffman’s many issues with ETFs is that they somehow pose a giant blowup risk for investors; that their value may simply disappear in a pile of grief and confusion. The report continuously refers to them as derivatives, a loaded word in today’s markets. They raise the specter of the government having to step in and rescue shareholders when an ETF issuer fails.

Here’s the logic of how they see an ETF issuer failing:

“In creating more ETF units, ETF sponsors are liable to purchase the underlying securities, and so the more units that are created, the greater are these purchase obligations. Yet because the underlying securities are in short supply, mounting obligations of ETF sponsors to purchase them exposes the sponsors to the risk that the cash they have on hand will be insufficient, at the sharply higher prices of the underlying securities, to cover those purchases and thus track the index.” Page 38

The levels of “Wrong!” in here are deep and profound. It reflects a serious misunderstanding of how ETFs work.

With the exception of a very few funds that rely exclusively on cash creations, ETF issuers are not “liable” to make any purchases whatsoever when new shares are created. The whole point of the ETF structure is to keep the fund (and thus the investor) from being on the hook for any transactions at all.

Kauffman mostly focuses on the iShares Russell 2000 ETF (NYSEArca: IWM), and on small-cap ETFs in general. To make new shares of IWM, an authorized participant has to deliver a specific basket of stocks to BlackRock. How does he do that? Most likely he puts in a market-on-close order to buy a big basket of stocks, which he knows—by definition—will be priced at the same closing price as represented in IWM.

If the AP can’t go buy shares of the stocks in the basket, he can’t make new shares of IWM. Assuming he can, everything works out fine: IWM gets the equity shares it needs, and the AP gets the IWM he wants.

Nowhere in this is there any risk to the existing IWM shareholder. IWM didn’t take a big pile of cash at the end of the day, and then have an obligation to race into the market tomorrow and get those stocks at any cost.

No, that nightmare scenario exists in a different vehicle: the traditional open-ended mutual fund.

Sorry Kauffman, better luck next time.

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