Hougan And Nadig Podcast Takes On Kauffman

November 11, 2010

Listen in on Matt Hougan and Dave Nadig as they roll up their sleeves and take on the flaws in the Kauffman Foundation’s report.

Much of the tempest of concern surrounding the Kauffman Foundation’s report this week fingering ETFs as a source of instability in financial markets stems from a fundamental misunderstanding about how these funds operate, IndexUniverse.com’s Matt Hougan and Dave Nadig said in their weekly podcast.

Hougan, president of ETF analytics at the San Francisco-based indexing and ETF news and data company, and Nadig, its director of research, banter weekly about the stories and issues of the day. But this week’s podcast was particularly pithy considering the seriousness of the charges in the Kauffman report.

The report, published Nov. 8, and covered at IndexUniverse.com, said ETFs were distorting the pricing mechanism for stocks, particularly small-cap equities, and were damaging the IPO market. The Kauffman survey also said ETFs were more to blame for the May 6 “flash crash” than high-frequency traders using computer programs. It said that without regulatory changes focused on ETFs, another flash crash was inevitable.

“The thing that was most galling … was that [their conclusions] were founded on such a simple and fundamental misunderstanding of how ETFs create and redeem shares,” Hougan said in the podcast, adding the study’s authors might have avoided the misunderstanding by visiting IndexUniverse.com’s ETF Education Center.

Nadig focused on the issues of shorting ETF and trade settlements, two of the bigger flash points of misunderstanding regarding ETFs that have garnered a fair amount of media attention, as Hougan’s appearance on CNBC this week made clear.

The Kauffman report, singling out the popular and heavily traded iShares Russell 2000 ETF (NYSEArca: IWM) as an example, charged that trades in IWM fail to settle in a timely manner far more frequently than regular stocks.

Nadig, citing sources in the ETF industry and at the Securities and Exchange Commission, acknowledged that the number of ETFs failing to settle three market days after the trade—T+3 in market parlance—is often higher than for regular stocks.

But that statistic is commonly misunderstood, not representing failed trades—where investors don’t end up in possession of their stock or ETF—but rather timing problems. Market makers, who are frequently on the other side of a trade with an institutional investor creating or redeeming ETF shares, have six days to settle instead of three.

“Because of that, you see this giant fail on something that’s got a lot of market-maker activity, and you think: ‘Gee, mom and pop didn’t get their shares,’” Nadig said. “No, what really happened is that the market maker’s taking a couple of extra days to deliver—probably rolling up enough shares to make a big enough basket to do a ‘create’ to make those deliveries.”

The first ETF was launched in 1993, and assets in U.S ETFs as of Nov. 10 totaled $978.52 billion, according to data compiled by IndexUniverse.com. By contrast, assets in U.S. mutual funds totaled $11.27 trillion at the end of September, according to the Investment Company Institute, the industry’s trade group.

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