Burns: Your ETF Won't Fail

Jeremy Glaser: For Morningstar.com, I'm Jeremy Glaser. Recently the Kauffman Institute released a report written by Harold Bradley on how ETFs could be a potential danger to the market and to the recovery as a whole. I'm here today with Scott Burns, Director of ETF Research for Morningstar, to take a closer look at this report and see if there is anything to it.

Scott, thanks for talking with me today.

Scott Burns: Jeremy, thanks for having me.

Glaser: So, what's your overall impression of this report?

Burns: Well, as a piece of research, I don't have a very high impression of this report at all. I mean, it's kind of a rambling diatribe that accuses ETFs of stunting the economic recovery to being the potential for future market collapses, and a lot of it uses – it's not a good research report in a good academic sense. I mean, there is a lot of selective examples taken, ignoring of contradictory evidence, and even just claims that are unsubstantiated, a lot of all, oh, I hear this from these people, and I'm going to call that a trend and call that research.

So, as a research report, I think, once you get pass the very incendiary executive summary, you will find that there is this very rambling kind of misconstrued piece of research contained in these 84 pages. And I think, what's really surprising and why people have picked up on it is that the author has what seem like extremely good credentials, and it looks and feels like a real research report. But as a researcher when you get into it, you start to realize that, that there are a lot of gaps in the analysis.

Glaser: Let's take a closer look at it then. One of the first things that's talked about is high frequency trading, and it's a defense of high frequency trading in a lot of ways. Is that something that you disagree with?

Burns: Yeah, actually, that part of the report, I agree with. I think, by and large high frequency traders are good for the market. I think, when we look at whatever money they are making and compare it to the grand amount of money that investors have saved over the past two decades as electronic trading has become more prevalent, the investors are actually coming out ahead. I mean, there is still a little bit of a skim that they are taking.

But when we look at bid ask spreads across the board and transaction costs, things have dropped dramatically. I think, what's most curious about the author's take on this is that while he is defending high frequency trading, he then kind of goes into this rant against dark pools of capital and follows that up with ETFs. As if high frequency trading dark pools of capital and ETFs are somehow separable items. I mean, they are a very symbiotic relationship between those things and the growth of high frequency trading. One, they need dark pools of capital with which to do that trading, and two, the ETF has helped to facilitate that and helped to really grow that market as well as a viable source. So, it's very kind of confusing argument of this is okay, but the things that they require are bad, so I don't really know how that jives.

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Glaser: And what about his take on the flash crash?

Burns: You know, the take on the flash crash was actually – it was pretty good. In the one – the suggestions that he made were all suggestions made by the industry and by other critics two months ago. So, hard to disagree with much of what he said although there are some things about not doing pricing bands and things like that, that I think are a little bit more suspect. But in general that's kind of old news that flew in there, but I think it's new news to people who are coming to it for the first time.

Glaser: Moving to the meat of the argument then, what do you think about the possibility of an ETF completely collapsing?

Burns: Well, so we wrote an article about this very simply called Your ETF Will Not Collapse, and really walked through the math and that the mechanism for why heavy short interest in an ETF, your short interest that exceeds what the actual shares outstanding are will not actually cause an ETF to collapse.

The author spent a lot of time picking on one particular fund iShares Russell 2000 over a period in the summer of 2007. This is what I found to be probably the most interesting gap in the research is through all that very heavy analysis on this one single fund and that one point in time, he paints his picture of illiquid securities that have to be bought up to meet this redemption of an outside short interest that is, the fund has 10 million shares, but there is 30 million shares worth of short interest out there.

So to collapse that you would have to buy up and redeem their shares outstanding, and that's the concern is that in an illiquid market that won't be able to happen. So the problem is and the problem with all these ETF might collapse arguments is what I like to call the absence of ruble. If a building collapses, we will see the ruble, right. That particular fund during that particular time period – it's a very large fund, $10 billion fund – suffered a near total redemption in June of 2007 at the exact time period that he is looking at. The author either missed that fact or I think more likely ignored that fact.

So the exact doomsday scenario that he and others have painted for how ETFs can and will in their words collapse has actually occurred, and yet there is no ruble, because the ETF did not collapse. The system worked, the structure worked, and things happened eventually. Now there was an instance that ETF in particular traded at a slight premium during that time period, but you know what, if you're a long ETF holder that's good for you; and if you own the underlying securities, and they have to go up to meet the redemption, that's good for you; and if you are a company listing in the small caps and your stock price goes up, that's good for you.

Really the person it's not good for, the only people it's not good for are the shorts, and in our culture and current mandate, I hate to say it, but the bias is always to benefit the longs to the expense of the shorts. And that's exactly what happens when these ETFs have with more or less a short squeeze.

But they don't collapse, and really what's frustrating about this argument is it's almost like arguing some of the more theoretical things out there such as creationism versus evolution there this just kind of proof gap out there, right. And so they can say all they want, like, oh, but it might collapse, but we have all this evidence that it hasn't, and that particular fund is just one example amongst hundreds of these doomsday scenarios that are painted playing out with the ETF not collapsing. So I am not sure how he missed that event in his research, the very in-depth research he did on that particular fund at that particular time period, but his doomsday scenario played out and nothing happened. So I think, it's pretty much an empty vessel right now, that argument.

Glaser: You mentioned with that kind of collapse that there could potentially be benefit to the small cap firms that are listed in the index. One of the claims report is that firms don't want to list on the exchanges any more. They want to go through the IPO process, because they are afraid of being included in indices and being included in ETFs. Do you think there is any truth to that?

Burns: Well, I mean, whether or not he's talked to some individuals who have that misguided perception, I am not really sure about. But, the academic evidence is very clear out there that companies, like companies, one is included in an index, one isn't. The one in the index trades at a premium. Being in an index is beneficial to the company, to the company's shareholders. It brings in a capital flow of permanent passive long money, and really doesn't care whether or not your company is good or not.

I think, the author makes this – again, ignoring kind of the facts that for every Google, there's hundreds of duds of IPOs, right. So it's almost like he is making a claim against diversification, which we also know all the academic literature says is a good thing that he wants to ban low cost passive ETF vehicles owning small cap stocks. I don't know how that's good for the investor at all, and may be some of these companies think that that will be good for them. But as we described in the melt up scenario in one of these short squeezes, if you own the company individually, that's good for you; if you are the company, that's good for you; and if you own the ETF, it's doubly good for you, because one, the value of the stocks goes up, and your ETF likely trades at a slight premium. So it's good for everybody except the short.

So it's a very confounding thesis to take that blaming the rise of ETFs for the lack of IPOs, I think, following Occam's Razor that the simplest solution is probably the best. I would take a look at the 10 year chart on the NASDAQ, and maybe there is your answer for why we've had fewer IPOs over the past decade.

Glaser: Now given your take on the report kind of begs the question, what was the motivation of writing it; it's not maybe immediately clear what the benefit that they would get, from a diminished ETF market?

Burns: Right, well, I mean, it's definitely gotten headlines for the group. I know, they have a conference coming up. So I mean, the timing was good for them. I think, some of the motives are around what I'd like to kind of call like the old guard reacting to what's happening in the new guard, the electronic trading market, I think, a lot of these critics would like to go back to a world where we were doing paper trades, and it cost a $100 to do a share transaction with huge bid ask spreads, and on the securities underlying. The ETF process is more complicated, it is more complicated, but it is not so complicated that you couldn't understand it after looking at it and understanding it.

It requires a lot of computers and there is lot of things happening and things like the flash crash, I think, there is the potential for that, there was the potential for that in the past because of this complexity, and really a failure for the exchange systems and regulations to keep pace with the complexity. But, the fact remains that when people are out there saying ETFs are opaque and not liquid, in the face of all the evidence that one of the reasons ETFs are so popular is that they are the most liquid, most transparent, and in general lowest cost investing vehicles that the American public has ever seen.

Claims to the contrary are confounding again. And I find it ironic when it's hedge fund managers claiming that, because hedge fund managers basically run structures that are the least transparent, most costly, and mostly illiquid ways to invest your money out there.

So, maybe there is a – if my enemy's enemy is my friend kind of thing going on there, but I think the motives for the media picking up on it so much besides the market being kind of flat, it's that ETFs are disruptive to the general media market.

t's something that you face as a site editor here at Morningstar. I mean, in a world built on a cult of personality, where I bring on a CEO, and I bring on a fund manager and we talk to them about what's happening with their business or their strategy. When we bring on an ETF, I mean, we can't ask the S&P retail index based ETF, why did you go up today. And when you look at ETFs are making up 35% to 40% of the daily trading volume and passive investing is becoming increasing more prevalent. A passive investor isn't really that concerned with what's going on in the market. I mean, that's kind of why they went passive by default.

So I don't know whether it's conscious or subconscious, there is this kind of knee jerk reaction right now to ETFs. I mean, they are so simple, I think, it's hard for people to believe that they actually work.

Glaser: Scott, thanks for taking the time.

Scott Burns: Jeremy, thanks for having me.

Glaser: For Morningstar.com, I am Jeremy Glaser.