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What’s Wrong with the Kauffman Report? To be honest, pretty much everything

Taken from iSharesblog.com

November 23, 2010


A lengthy new report from the Ewing Marion Kauffman Foundation, a Missouri-based group that promotes economics education, says some pretty scary things about exchange traded funds (ETFs). Unfortunately for a foundation that aspires to teach people about finance, this irresponsible report gets basic facts wrong and promotes a fundamental misunderstanding of how ETFs work.

With appendices, the report, called “Choking the Recovery,” weighs in at 84 pages, so I won’t cover every aspect of it. But the gist of its argument is this: ETFs, the report says, pose “unquantifiable but very real systemic risks” to financial markets. Why? For two alleged reasons. One, “the ease of short-selling ETFs” could lead to market freefalls like the infamous flash crash of May, 2010, in which the Dow Jones sank about 600 points in a few minutes before recovering. There’s absolutely no evidence of that phenomenon, and the SEC report on the “flash crash” pointed instead to high-frequency trading.
The report also argues that ETFs are vulnerable to a “short squeeze,” in which investors need to cover shorts but ETF sponsors lack the cash to buy the securities underlying an ETF. That could lead to a “failure” of an ETF, says the Kauffman report, eventually leading to a “market panic.”

There’s just one problem: This argument is based on a fundamental misunderstanding of how ETFs work, and as a result, it—and the Kauffman report in general—are hard to take seriously.

Let’s look more closely at the report’s argument. The report warns of the dire consequences of a short squeeze on ETFs [a steep rise in ETF price triggered by the urgent need of many borrowers to purchase a borrowed ETF or its underlying securities, and return the ETF to the lender].

But ETF sponsors aren’t vulnerable to a short squeeze. That’s because, in order to create new shares of an ETF, an authorized participant—a firm responsible for bringing ETF shares in and out of the market—must first transfer the relevant basket of stocks of which the fund is comprised to the ETF sponsor. In return, the sponsor gives the authorized participant ETF shares of equivalent value. So ETF sponsors aren’t transferring shares of borrowed assets; they’re transferring shares that represent assets in their custody. This structure actually anticipates the very problem the Kauffman report spends 80-plus pages warning about. If the report doesn’t understand that basic point, it’s clear that the authors do not understand how ETFs work.

What’s the truth about ETFs? They can help investors, both large and small, expand their investment opportunities, especially in global markets they otherwise might find difficult to access. And ETFs generally have low fees and are tax efficient. Those benefits of ETFs—and not false claims based on financial misunderstanding—should be the real message of the Kauffman report.

Transactions in shares of ETFs will result in brokerage commissions and will generate tax consequences. ETFs are obliged to distribute portfolio gains to shareholders. With short sales, an investor faces the potential for unlimited losses as the security’s price rises.

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