How ETFs Are Changing the Market

Tuesday Sep 26th 2006 by Brian Livingston

Technology is fueling the proliferation of "exchange-traded funds" on Wall Street.

Whoever said, "There's nothing new under the sun," obviously never worked on Wall Street.

High-powered trading institutions spend a great deal of their time dreaming up ever-stranger ways for people to bet on the direction of anything that moves.

Options, futures, financial derivatives -- depending on whom you speak with, all of these add liquidity to global capital flows or increase the risk of cascading losses.

Innovation in the markets is by no means over. In fact, it's just beginning -- in the brave new world of ETFs.

Growth of a New Investment Vehicle

ETFs are exchange-traded funds: a collection of stocks, commodities, or market indexes. They can be bought and sold whenever an exchange is open. By contrast, mutual funds -- which ETFs superficially resemble -- are required in most countries to declare a price, and therefore an opportunity to buy and sell, only once at the end of each day.

ETFs weren't invented yesterday. They've been in development for years. But they're now in a period of rapid growth that may change the very nature of financial markets. There are a little over 250 ETFs today. Within a few years, there'll be thousands.

Taking the Pulse of an Economic Sector

Financial firms can create ETFs around any kind of indicator. It could be stocks in a market sector such as health care -- but only "low-capitalization" health-care stocks, those valued, say, at less than $500 million. This precision allows institutional investors and large hedge funds to bet on the direction of an entire industry or subindustry, not just individual companies.

"That's why ETFs are created," says Harvey Baraban, a long-time observer of Wall Street. "They're created to serve the hedge funds. The hedge funds can buy them and short them whenever they want."

Baraban was the CEO from 1978 to 1989 of Baraban Securities, which at the time was the largest independent brokerage firm in California, with more than 1,500 brokers. Now retired, he trades his own accounts and gives occasional public lectures on personal investment strategies.

ETFs, as he describes them, would be impossible without today's level of ubiquitous computer technology. Unlike a mutual fund, which is simple enough to be run by a single individual making a few trades per day or week, an ETF requires instantaneous rebalancing. Only computerized trading will do. Here's why:

Establishment. An investment firm, such as Barclays or Vanguard, sets up ETFs focused on offerings like transportation stocks or gold or the S&P 500 index.

Inflows. As soon as an ETF is opened to the public, cash from new investors streams in (and also streams out, as withdrawals start to flow into other vehicles).

Balance. Mutual funds can allow new cash to build up for days or weeks if no promising investments present themselves. Most ETFs can't wait a day. If an ETF is based on an index of stocks in a particular industry segment, for example, cash inflows and outflows must immediately be used to buy and sell the underlying equities -- in exactly the right proportions -- so the value of the ETF exactly tracks the index.

Computers, naturally, make this constant rebalancing possible. ETFs can be relied upon to exactly mirror an index comprising scores or hundreds of individual investments. For this reason, hedge funds -- which usually limit participation to investors with $1 million or more in liquid assets -- have found ETFs to be an excellent way to go long, go short, or play the spreads on entire baskets of bets at once.

Exotic trading strategies are the bread and butter of hedge funds. The U.S. Commodity Futures Trading Commission reports that 46 percent of open positions in natural gas futures and options, as of Sept. 5, were spread trades, not simple long or short positions. ETFs, which can be shorted or optioned, are interesting enough to attract plenty of hedge fund money.

Realizing Your Financial Destiny

By all accounts, ETFs were not implicated in the financial fiasco that befell Amaranth Advisors, once one of the United States' 40 largest hedge funds, earlier this month. Amaranth, which lost a reported $6 billion (almost two-thirds its entire portfolio value) had made giant, leveraged bets that March 2007 natural gas futures would remain much more expensive than April 2007 futures. The spread collapsed due to a swift decline in natural gas prices, and the rest is history.

There's no reason, however, that ETFs couldn't be involved in such a catastrophe. They could play a role in an even larger debacle, as ETFs grow to represent more and more market volume.

Hedge funds already account for more than 30 percent of trading in U.S. equities, according to Baraban, and some observers say the figure is as high as 50 percent.

Such funds are currently unregulated in the U.S., possibly due to the fact that hedge-fund principals are heavy contributors to both Republicans and Democrats.

Here's one example: Large pension funds and other retirement funds increasingly are turning to the hedge fund industry in search of improved returns. "The industry lobbied for an amendment to the federal pension law that would make it easier for hedge funds to handle pension money without being held to the law's fiduciary standards," writes reporter Mary Williams Walsh in the Sept. 20 issue of the New York Times. "Such a provision was included in the pension measures signed into law by President Bush in August."

In this space next week, I'll look further into how technology is pushing ETFs into more and more corners of the world's markets, for good or ill.

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