(12/29/11) Debunking 3 ETF Myths

WisdomTree's David Abner discusses misconceptions about ETF product proliferation, liquidity, and the flash crash, as interviewed by Robert Goldsborough of Morningstar.com.

Robert Goldsborough: I am here today with David Abner, the director of WisdomTree's institutional ETF sales and trading group. We're here to discuss several myths involving exchange traded funds, and I'm going to open it up with three questions for David.

David, first, can you talk a little bit about the notion of ETF product saturation? With more than 1,300 exchange traded funds and exchange traded notes right now in the market, a lot of industry critics have said that there may be too many products. Can you address that?

David Abner: Sure. Thanks, Bob. I'll start by saying that I don't think the ETF market is saturated at all, and the most clear comparison I would pull is the mutual fund industry. Currently there are roughly 10,000 mutual funds in existence, and with only 1,400 ETFs outstanding, I think, we've got a lot of room to grow.

I think you'll see growth in a variety of ways in the industry, both into new and untapped asset classes. I think you will see growth in product structure, so there is possibly a lot of growth in the actively managed exchange traded fund area, and then you'll see some growth in terms of new products where people have not been able to get access before.

I think the biggest measure that you could use is by looking at some of the ETF issues that have come out recently, and you're seeing some assets, some real assets raised, which means that products have come out where investors haven't been able to get that access or haven't had access to a fund of that style. And they're putting money to work in those products. That's the way it works.

Goldsborough: On that same score, there has been a lot of criticism about thinly traded ETFs, and this is a notion that an ETF that has low volume must also be an ETF that is not liquid. Can you address that and whether or not is that a valid complaint on the part of an industry critic?

Abner: Absolutely. The biggest misconception in the ETF market is that volume equals liquidity, and I like to say, and I'm a tremendous proponent of saying, ETF volume does not equal ETF liquidity.

The actual measure of the liquidity of an ETF is a function of the underlying basket primarily. So, the volume that you can trade in the underlying stocks or whatever the underlying asset is will determine both how much ETF volume can potentially be traded and what spreads will also look like in that ETF.

So, it's this big notion of how do I get liquidity in an ETF. I do meetings every day with clients, and one of the main topics is: "Well, I have a lot of shares to buy, but this ETF doesn't seem to trade enough."

And I go through the entire process of how creation and redemption enables market makers and liquidity providers to provide liquidity in an ETF. Because of the spontaneous creation and redemption process, potential ETF share liquidity is much greater than what you might see in a volume number.

Goldsborough: Makes perfect sense. Can we shift gears a bit and talk about the flash crash in May 2010. There continues to be a pervasive misconception we think among investors and among the broader public that ETFs caused the flash crash. Talk a little bit about your perspective on that?

Abner: Sure. Well, it was clear from the SEC and CFTC report of September 2010 that they exonerated ETFs as the cause of the flash crash. So, we know that they did significant research on the markets and they determined that ETFs did not cause the flash crash.

What still lingers is people's lack of a deep understanding of what was really going on that day. I think the easiest way to express it is to give people a view of what it looks like to be an ETF liquidity provider.

In the simplest terms, if you are an ETF market maker, or—I use the terms interchangeably—an ETF liquidity provider, you typically have two systems on your desk.

You have one system that is using the most recent quotes on a basket of stocks or whatever the underlying is and is calculating an implied market in the ETF that you would be using to provide that liquidity. And you also have a backup system that's using a different quoting source, and it's also calculating from the underlying or from the basket what the implied price of the ETF should be.

You have both of those systems in your desk or in your systems, electronically. One of the main tasks on your systems' integrity is that the two prices that you are calculating should be equal. So, you know that your systems are working properly that both pricing sources are doing their job.

At the time of the flash crash, it's well-known from the report that the SEC and CFTC published that there was a quote delay coming from one of the major exchanges. So, there were slow quotes going on. There was a delay on certain names.

What that would do is if you're an ETF market maker...all of a sudden your main pricing source and your backup pricing source would not agree. If you're an ETF market maker in that situation, you would immediately move to limit your risk.

So, if you have trouble calculating the intrinsic value of the ETF, you will move away from the inside market until you can figure it out. At the exact time that happened, there was a flood of market orders that hit the system, and I said during my presentation that I think that was due to stop orders turning into market orders when limits were triggered, and that was a byproduct of what was going on in the flash crash.

But it's this process that you need to be able to calculate fair value to be able to make a market in liquidity, which is crucial. That's where people miss out and think that the market-making community was not doing their job.

What you see in the flash crash is that prices immediately rebounded as soon as quote spooling caught up. So, market makers were immediately there and willing and able to step back into the market as soon as they saw that there was integrity between their two systems.

Goldsborough: From a quote delay standpoint, what is it that you think prevents another flash crash from happening again?

Abner: Well, I think that systems have been upgraded and some of the regulations around how trades are canceled and things like that have been clarified. So, I look at the flash crash, and I say it was a third-highest volume day in ETF history. If it's only the third-highest, that's not an anomaly in ETF trading.

And what you're seeing is those highest volume days are actually getting bigger, and flash crash day is going to continue to move down the list. Because as market events, as world events happen, and the markets react, people are using ETFs more and more to achieve the positions and the exposures that they want on both sides—long and short—in the markets.