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Can ETFs Collapse?

Image Source: AFP Photo/Greg Baker

In 2010, an article released by Bogan Associates, a Boston-based investment firm, questioned the stability of ETFs in the event of a run. The article raised eyebrows over the very structure of ETFs and caused fear to spread among investors. And today we are going to show you why they are wrong.

With the 2008 financial crisis still in recent memory, we can understand why Bogan Associates would fear another great financial crisis caused by derivatives. However, by showing you the basic structure and safeguards in place for ETFs, we will show you why Bogan’s fears are quite unfounded. First of all, it is important to highlight that ETFs are not derivatives, unlike the mortgage-backed securities which so spectacularly blew up in investors' faces during the Lehman crisis in 2008/2009. So let us try to understand the structure of ETFs in our first step. Most people prefer ETFs because of their lower expense ratio costs and higher liquidity as compared to mutual funds. Mutual funds tend to directly buy and sell stocks. This will raise turnover rates, tax liabilities, and overall costs for mutual funds. ETFs are more stable because there are two markets for ETFs, a primary and secondary market.

Image source: Northern Trust Corporation.

The primary market is strictly concerned with the creation of ETF shares themselves. In this market are the Authorized Participants (APs) and ETF sponsors. APs provide the ETF sponsors with the physical components that comprise the ETF. In return, the ETF sponsor will give the APs the ETF shares. This market helps insure that every ETF is backed with the appropriate underlying securities. After ETF shares are created and given to the APs, they will sell it on the secondary market to investors. This is where you and I will come in. Trades on the secondary market have no effect on the underlying securities that composes the ETF. The issuer doesn’t have to do anything when you buy or sell ETF shares from another investor. This is a great benefit as compared to mutual funds where trades from a single investor can affect everyone else in the mutual fund.

Differences in bid-offer spreads between ETFs and underlying securities do exist. There are a group of arbitrageurs in the primary market who help redeem or create shares as needed. This will help keep the liquidity of ETFs if the bid-offer spreads get too large. This ability to create and redeem shares in the primary market between ETF sponsors and APs is a critical component in the structure of ETFs. Their profit-maximizing behavior will insure that ETFs will never collapse. And as long as fully-replicated ETFs are considered, no other counterparty risk (like in the case of swap-based synthetic ETFs) enters the equation, either.

The article by Bogan Associates highlighted concerns about short-selling practices in the ETF market. The article stated some situations where there were more owners of ETF shares which collectively outnumber the actual ownership of the underlying securities.[1] The article by Bogan Associates hypothesized a possible situation where an ETF fund could not pay all their shareholders in the event of a run. The article concludes with the question “who gets left holding the bag?” when all shares available have been redeemed.[2] Morgan Stanley’s Jason Warr helped address these fears during his interview with Morningstar in 2010.

The short interest is greater only because of the lending that is going on between different counterparties. If someone wants to sell an ETF, they must borrow that ETF from a long holder in order to facilitate settlement of the sell trade. If they can’t locate borrow [sic] then someone has to create on their behalf to facilitate settlement of their sell trade. This creating-to-lend generates new assets in the fund. The person at the start of that chain who physically sold the ETF doesn’t have a problem. The person at the end of the ETF who physically buys it doesn’t have a problem either… The scenario [Bogan Associates] was concerned about was that the investor at the end of the process might not be able to redeem their ETFs. This is not the case. In the US, the DTC ensures the settlement of all ETFs. So if the ETF is traded it should settle. If the ETF settles it means that you will physically own it. And if you physically own it you can physically redeem it. [3]

You read it right. No ETF share is created out of “thin air” without underlying securities to back it up. Thus, every ETF share created is guaranteed to settle in the event of a possible run on the fund. There are also other safeguards in place to help prevent a complete collapse of an ETF. Similarly rigorous legislation exists under the UCITS frame work in Europe for ETF structures in European countries.

Of course, with every investment there are risks involved. ETFs can absolutely lose their value, if you pick the wrong fund to invest in you may lose money. But being left with an unredeemed ETF share in the event of a shutdown won’t be one of the risks involved. Keep in mind that we are discussing fully-replicated ETFs and not ETNs or synthetic ETFs. The world may end and the earth may be destroyed in hell fire, but at least the structure of ETFs will stand indefinitely.

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