In a recent post, Felix Salmon of Reuters asks the question “Should ETFs be allowed to include illiquid stocks?” He notes:
I do think that a lot of investors like ETFs precisely because they have a certain degree of liquidity which is often missing from the underlying stocks. But I suspect that it’s even harder to create liquidity out of illiquidity than it is to create a triple-A credit rating out of junk-rated subprime securities. You might be able to credibly pretend that you’re doing it, but there’s a strong whiff of fakery as well.
And that is a very fair point.
However, Salmon’s explanation as to the reason why illiquid stocks in ETFs are bad for the market generally is a little muddled. He says:
Let’s say that you’re a predatory algo and you’re looking at activity in these ETFs with substantial holdings of small-cap stocks. When people are buying, you quickly load up on the underlyings; when they’re selling, you go short. Your activity will eat into the returns of the ETF, since you’re making it more expensive for the ETF to buy the stocks, and getting it a worse price when it sells. But more to the point, it will maximize volatility and room for manipulation in the underlying stocks, as well, while minimizing the useful information to be gleaned from their share price. If you buy straddles on these small companies — equity derivatives which pay off when volatility is high — then it’s easy to imagine how you can trigger payouts by playing around in the ETF space.
What is actually the case is that the ETF “arbing” market has become two-tiered.
It’s important to remember that an ETF never actively goes out and buys stocks itself, despite what Salmon suggests.
The ETF instead depends on dedicated “authorised participants” to do the job — and these entities are the only ones that have the right to create and redeem ETF shares at true net asset value.
But that doesn’t mean that what Salmon says is not happening.
Market sources tell us that independent HFT firms are increasingly undermining the profitability of ETF arbitraging for APs, by acting ahead of them.
You see, APs are not going to act unless a worthwhile arbitrage is there for the taking. Illiquid underlying stocks complicate this matter, because even if there is on first glance an opportunity, the hedging process needed to lock it until NAV creation/redemption time (which only happens once a day) becomes far more expensive and ineffective if the underlying stocks are illiquid.
Hence APs will wait on the sidelines until the arb is so big that it is worth pursuing — knowing as they do that there will always be some form of slippage in the illiquid part of the basket they have to submit.
The ‘predatory’ HFT units, meanwhile, have cottoned on to this problem. The APs’ sitting and waiting process provides them with a latency advantage. As Salmon explains, the HFTs now have the opportunity to pre-empt them.
When the stock unit of the ETF gets too far out of whack with the underlying, they simply pick up the illiquid stocks knowing the AP will be prepared to suffer slippage in order to complete his basket.
This slippage problem is actually one reason that many ETFs amend the composition of their stock baskets on a regular basis. So even if the ETF is designed to track index X, which is made up of say 200 stocks, the APs are only required to deliver or pick-up the most liquid stocks within that index — the optimisation specifically designed to mitigate the illiquidity problem.
Of course, that’s not always going to work if the underlying is illiquid from head to toe.
And perhaps it creates other problems too (like exaggerating the two-tiered nature of liquidity across specific indices).
Nevertheless, it should come as no surprise — especially as products get increasingly more exotic and diverse — that liquidity issues remain a key factor behind ETF deaths every year.
So sad.
Related links:
When is a market maker not a market maker? – FT Alphaville
How ETFs fueled high frequency trading - FT Alphaville
ETFs and the ‘flash crash’ – FT Alphaville