ETFs, Their Alter Ego, and the Future

(previously published on LinkedIn)

Far from the original “spider” ETF, many of today’s ETFs look to deliver new kinds of returns in a wide range of markets. The recent Icahn-Fink debate over fixed income ETFs, the recent SEC release on leveraged ETFs, and the perennial debate around futures-based ETFs all look like separate issues, but they all go to the same basic questions – what are ETFs supposed to be, and how are ETFs supposed to interact with (or be isolated from) the larger market. Further, ETFs almost always face an identity crisis prior to launch – in order for a new ETF to be useful it must deliver something currently unavailable, but at the same time, it must be the same as everything that’s come before it so that it can be easily regulated, valued, and arbitraged.

In an ideal world, ETFs would deliver perfectly intuitive returns and continuous liquidity, while neither impacting nor relying on underlying market limitations. As a testament to the ETF industry, it actually has done a remarkable job of launching useful and effective tools which fit neatly into available liquidity and real-world constraints.

Where Are We Going In the Near Term?

New ETFs will continue to present two faces to the market:  the new-new thing on one hand (to the media and investors), and “nothing to see here” on the other (to regulators and market makers). This approach may become impractical as the industry tries to deliver new tools and to fix old ones. Nobody likes the idea of flashing 15-second indicative values over a pool of trade-by-appointment high yield loans for the “benefit of” fixed income ETF investors; but where there’s a demand for access to otherwise challenging market exposures, the industry should evaluate how to best deliver it – even where the delivery solution is not based on the original “spider”.

ETF Myopia.

A good consequence of our vast ETF market is that investors and traders don’t need to leave ETFs to trade an almost unlimited range of long, short and hybrid positions. A bad consequence of our vast ETF market is ETF myopia – that is, ETF investors and traders usually forget that there’s a trader or counterparty on the other side of every ETF share; somebody bought, sold or swapped something for the ETF to create its shares. For example, an explosion of AUM in a commodities ETF doesn’t mean everyone’s a buyer or a bull, but rather it means that (at that commodity price) there’s a whole lot of futures-market sellers willing to go short to ETF investors. Using the ETF market as one’s sole lens into market trends is almost certain to miss half the story.

Where Are We Going In the Long Term?

The original spider has taken the industry through over two decades with thousands of launches across hundreds of markets. As the ETF industry continues to explore new markets and improve on old ones, it’s likely that variations on the spider formulation, if not wholly new solutions are likely to be advanced.

In particular, if we can read the range of analysis and questions in the SEC’s recent proposal (on derivatives in leveraged funds) as constructive, the industry may have an opening to both keep some old solutions and to advance new solutions in response to long-standing market demand.