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The ETF marches on. Traders Magazine Online (14 July) reports that the volume in ETFs is exploding. According to the article, from last September through May, “ETF consolidated volume averaged almost 49 billion shares a month. That is compared to almost 20.5 billion a month on average from the same period one year earlier.” This 150% jump follows a report where the NYSE found ETF consolidated volume on average doubled in comparable nine-month periods.

In other words, not only is ETF volume growing tremendously, it is growing at an accelerating pace. We hold no degrees in rocket science – nor in any science – but we wrote earlier that the entry of such behemoths as PIMCO in to the ETF space all but guarantee that this market will soon top one trillion in assets. Now, according to the Traders Magazine article, it appears that even the sky may not be the limit.

The article reports that Knight Capital has hired a team of fifteen ETF sales-traders to take advantage of “a tidal wave of volume and liquidity in the ETF space.” In fact, Knight is going after a whole new customer base.

“We're seeing more traditional mutual fund managers converting more into ETF format for the lower cost structure and transparency that ETFs provide,” says a co-head of Knight’s ETF group.

Traditional asset managers have been steadily increasing their ETF exposure, using them for “core holdings, beta exposure, alpha generation, various hedging strategies. Whether you're bottom-up or top-down, they can be very useful.” Something for everyone, it would seem.

Indeed, the article makes the following observation: “a traditional asset manager with money for a new account may want to be invested right away. Simultaneously, he also wants to wait two weeks to do some research on some stocks. While doing that research, he can invest the money in a value ETF and, at least, get the exposure until he has the individual stocks he wants to buy.”

This means that money managers who haven’t yet figured out what stocks to buy are sticking cash into an index, while figuring out what to do. All right, we already admitted to not holding a degree in rocket science, but we wonder whether this lax approach to managing money is “demand-pull” or “supply-push”. Did some smart money manager figure out that this is a good way to buy time while he does his homework, or are smart salesfolks hitting up money managers with hot new ideas?

In today’s interest rate environment, it makes little sense to park in cash while making an allocation decision. Thus, an investor might assume that a money manager had ideas at the ready – the notion of being 100% invested, 100% of the time is a key selling point to private investors. We will content ourselves here with smacking the same bell we have been ringing all year: the ETF trade risks becoming very crowded, very quickly.

ETFs and ETNs appear to trade based on two levels of price insensitivity. First, the ETF sponsor does not care at what price the individual components are bought for the Fund or Note – their concern is having sufficient holdings in the underlying instrument to be able to issue their shares. Secondly, the ETF buyer in the marketplace is looking, not at the price of the share, but at the action in the underlying index. Thus, Best Execution appears to go out the window.

Brokerage firms have written best execution procedures for ETF trading, but the ones we have seen are just retreads of their procedures for best execution of stock trades. This begs a big question: if the floor traders are scooping up stocks, indexes, oil, gas, and gold based purely on size and timing – with no consideration for price – and if the customer is buying the ETF based on the price of the underlying instruments, on what basis would anyone ever request price improvement?

While this looks like a facetious question, we call your attention to the CFTC’s new initiative to impose speculative position limits on all commodities “of finite supply.” This means all natural resources, and much hoopla erupted in the last two weeks about shares of the ETF UNG – the natural gas contract – which literally ran out of supply when the SEC did not authorize new notes to be issued.

This has created a situation where the ETF becomes sensitive to actual market demand on the offer side – more buyers of the now-finite ETF will actually drive up the price beyond its intended relationship to the underlying contract. The bid side of the market might hypothetically remain tied to the underlying natural gas contract; the problem here is maintaining a fair and orderly market. If a buying panic develops – not impossible in a world where Russia needs to spike the price of oil and gas just to keep making bread and vodka – the market makers may find themselves forced to chase the offer, raising the bid beyond its relationship to the contract.

But it gets better – because if the market regulators see the natural resource ETFs and ETNs spiraling out of control, they will beat their chests and say how very right they were. The introduction of position limits in the actual corn, gas, soybean and pork markets should be something most professional traders can get used to. What the locals will miss, once the shackles are on, is the free money they were scooping up filling price-insensitive orders for the ETF managers.

After that, we think SEC Chairman Schapiro starts applying the same logic to the stock market and the indexes – perhaps not the broad ones, but the narrow-based sector tracking indexes, most probably.

Earlier this year, there was a great outcry by the senior executives of REITs who complained that their shares were being whipsawed in the marketplace by ETF creation and liquidation trades.

Public companies have fixed numbers of shares outstanding, and even under a shelf registration, new shares are not issued intraday. We think CFTC Chairman Gensler’s proposed position limits are a done deal. The Next Big Thing, though, may be similar restrictions in the equities markets. In short: the ETF marketplace is big and growing – for the time being, though, it is decidedly messy.

We keep coming back to our old conclusion: Goldman bowed out of the bidding for iShares. Could Goldman have won, if they really wanted to? We think so.

Is it safe to assume Goldman knows something we don’t?

Count on it.

Source: The Incredible Growing ETF Market