David Abner Debunks 5 Popular ETF Myths

by: Morningstar

By Samuel Lee

David Abner is known in the exchange-traded fund industry for a dense tome on ETF mechanics and valuation, so he's well-situated to comment on five big "ETF myths." He works as WisdomTree's head of institutional sales, so he's not a disinterested source. But he's clearly an expert on his subject with a long career in ETF trading and arbitrage. He makes a spirited defense of ETFs.

The five big myths:

1) "There are too many ETF products."

Abner's response here is wanting, as is the question in the first place. It's a straw man; what is the "right" number of ETFs? We don't know exactly, but, under our capitalist system, it's the number set by supply and demand. Bad ETF ideas tend to die out--maybe not in a final sense but instead consigned to irrelevance with miniscule assets. In fact, the bulk of ETF assets are in a handful of low-cost, ultraliquid passive vehicles. We can re-interpret the "myth" to be: "There are more ETFs than there are assets there to support them." This may be true. Abner points to rapid growth in the number of ETFs versus ETF aggregate assets; this doesn't debunk the myth, as a handful of big ETFs can (and do) drive growth in ETF assets.

2) "No liquidity in many ETFs."

Abner is at his best describing ETF liquidity. It's not as simple as looking at the ETF's volume; a better approximation is the liquidity of its underlying holdings. Even this isn't the whole picture, as market-makers and traders can use correlating assets such as options, other ETFs, and customized stock baskets to off-set an exposure to an ETF. The real principle is how liquid and cheap and good are all hedging options out there for an ETF? Sadly, this discussion will remain theoretical, as this information is kept locked up in traders' proprietary systems.

3) "ETFs caused the flash crash."

The SEC and the FCC released a report pinning the blame on a mutual fund company, Waddell & Reed, and an ill-advised dumping of S&P 500 e-minis futures.

4) "ETFs can collapse from too much short-selling."

Abner stresses that only a handful of ETFs have more short-interest than assets--16 out of more than 1,300 by his count. So, even if true, the possibility of collapse wouldn't affect most investors. He argues that the creation/redemption mechanism allows supply of ETF shares to expand elastically to cover all the short interest. The argument wasn't the most fleshed out, as the collapse scenario occurs when there is naked short-selling. Abner didn't satisfactorily address that issue.

5) "Settlement fails are a cause for concern."

ETFs disproportionately account for settlement fails, which occur when actual securities are not delivered to counterparties within the stated period, usually three days after the trade date (T+3). Abner lists three reasons why this isn’t cause for concern. One, authorized participants, the institutions that can actually create and redeem shares with ETF sponsors, operate under T+5, leading to natural mismatches. There’s some stock loan latency; the loan market dries up at 3 p.m. EST, whereas much high-frequency ETF trading occurs at the end of day, leading to delays. Finally, sometimes there are creation/redemption delays with ETF sponsors that push back delivery a day.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.