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I had a fascinating conversation on Friday with Harold Bradley, the CIO of the Kauffman foundation. He’s something of an expert on high-frequency trading, quantitative strategies, and the like, and he raised an interesting question: Why isn’t the SEC banning ETFs which include small, illiquid stocks?

The question arises in the context of a stock market which is demonstrating more lockstep than ever: stocks are ever more correlated with each other, and instead of broad indices aggregating lots of different moves in different directions, as they did in the past, increasingly it’s the other way round, and stocks just move up or down depending on what the broader market is doing.

The rise of ETFs, especially in the day-trading space, surely exacerbates this syndrome. As ETFs tied to the S&P 500 get bought and sold in enormous volumes, arbitrageurs, many of them high-frequency automated algos, jump in to buy and sell the underlying stocks. It’s something that some people are worrying about, in that it cuts against the idea that the stock market is meant to allocate money efficiently between companies.

But when ETFs include small, illiquid stocks, the situation is even worse. Right now, the SEC says that 70% of securities in an ETF must be “actively traded”, or 50% if the ETF includes 200 or more securities. Which means that ETFs can have up to 50% illiquid stocks, which are relatively easy to manipulate.

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.

“We have a lithium battery ETF”, says Bradley. “These are designed for manipulation. What we’ve done is create derivative packages that give people the illusion they can trade small-cap stocks for cheap. Just because they’re in an ETF doesn’t make them liquid.”

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.

Clearly the SEC is concerned about manipulation, since it put in place those 70% and 50% limits in the first place. But if limits should be put in place, why not set them at 100%? This is a genuine question, incidentally: I’m not saying that Bradley is right here. But I do think he’s asking an important question.

Source: Should ETFs Be Allowed to Include Illiquid Stocks?