ETFs: Still the Right Call for Prudent Investors?

Jan.14.11 | About: SPDR S&P (XRT)

A case can be made that a trustee with an obligation to prudently invest funds held in trust (e.g. estate and trust funds) should use index funds and/or exchange-traded funds (ETFs). As Scott Simon argues, research shows stock pickers and actively managed funds tend to trail passively managed funds, so a trustee would not be doing their job unless they opted for index funds and ETFs. This week, however, I received some interesting emails from a trustee questioning that belief on two counts.

1. Large short positions in ETFs

First, he was rather surprised to learn from recent studies (Bodan Associates and the Kauffman Foundation) of the extent to which ETFs are sold short. As popular as ETFs are with investors for gaining low-cost access to markets, they are also popular with hedge funds, which like to short ETFs to neutralize the impact of market movements on their bets. Some ETFs are so popular with short sellers that the number of units sold short exceeds the number issued (some people, rightly or wrongly, call these situations “naked short selling”).

The worse case (as of June 30, 2010) was the SPDR S&P Retail ETF (NYSEARCA:XRT), which had 17 million shares outstanding versus 95 million (562%) sold short. In a sense, this is a “fractional reserve stock ownership system” (enabled by the ETF’s mechanism for the creation and redemption of units), claim the authors of the Kauffman report.

In the studies mentioned above, the fear is raised of possible “short squeezes,” counterparty risk and “possibly the potential for a run on an ETF – where the assets held by the fund operator could become insufficient to meet redemptions.” These claims are disputed by many observers, but the complexity inherent in the situation is enough to lead many, such as the trustee, to be concerned about complying with their duty to be a prudent investor.

2. Securities lending

Second, after reading some articles on securities lending by ETFs (including mine at Investopedia.com and Canadian Business – hence his email), the trustee felt that the practice had features and risks that might not fall under the prudent category.

Securities lending occurs when ETF managers lend out the fund’s securities to short sellers for a fee. The trustee found this disconcerting because “a trustee would never loan stock.” Also, the managers were making money from setting up bets against the securities they held for ETF investors. While such a “conflict of interest” may be acceptable to the fund company, “a trustee cannot have such a conflict,” he said.

Another thing about securities lending is that fund managers take all or substantial portions of the gains while ETF holders are left with all of the risk. Such a disconnect between reward and risk fueled the subprime-mortgage crisis; like the banks recklessly giving out mortgages in the knowledge they could be kept off their balance sheet through securitization, fund managers could end up pursing securities lending in an irresponsible manner given the risks don’t fall on them.

Operationally, this trustee appeared to be arguing, ETFs are black boxes where a lot of things are going on behind the scenes (and through over-the-counter markets), which give their operations an opaqueness and complexity that renders it difficult for trustees and other prudential investors to assess compliance with their obligations.