In 2020, the resiliency of exchange-traded funds was on display as the products withstood the market gyrations of the spring. Now, a confluence of forces in 2021 may test ETFs yet again.
For the most part, ETFs were an afterthought in the recent run-up and run-down of stocks (or "stonks") targeted by boosters on the Reddit Inc. forum WallStreetBets last month. But that doesn't mean that ETFs are immune from coordinated action by retail traders or any others. Do ETFs have the mettle to handle a mob without a cascade of unintended consequences?
Take, for example, a rumor that the Reddit community was targeting silver shorts via trades in BlackRock's iShares Silver Trust. A surge in volume helped push the trust's premium to an abnormally high 5.57% on Jan. 28 and its price up 7% on Feb. 1. Though both the premium and price of SLV collapsed on the following days, the unusual activity was enough for BlackRock to update the product's prospectus on Feb. 8 to indicate that both a delay to source silver for new share creations or a short squeeze could cause the product to trade at a premium.
The momentum and performance of ETFs managed by ARK Investment Management LLC have also made them a favorite of the WallStreetBets crowd. Led by CEO and CIO Catherine "Cathie" Wood, ARK's seven ETFs now command more than $57 billion in assets, 15 times more than they did a year ago, with its flagship actively managed ARK Innovation ETF now managing $26.8 billion with five-year annualized performance of 61%, according to ETF.com.
This surge in assets has some ETF watchers re-evaluating the potential market impact of large ETF trades, but Ms. Wood is unfazed. "If we're right and the platforms and technologies scale the way we expect, then our capacity should scale exponentially as well," she said on a Feb. 12 webinar. "Innovation solves problems," she said, and pointed out that new issues through initial public offerings and special purpose acquisition companies, as well as secondary offerings, are growing the pool of investment opportunities.
The sometimes contentious relationship between exchange-traded products and their underlying holdings is a hot topic among academics, with myriad conclusions. In a 2018 paper, Ayan Bhattacharya of Baruch College and Maureen O'Hara of Cornell University argued that ETF prices and trading supply additional information to markets and can exacerbate herding in an underlying asset, particularly for those that are less liquid, such as leveraged loans, foreign stocks or bonds, and commodities.
Conversely, the authors of a 2019 paper entitled "Intraday Arbitrage Between ETFs and their Underlying Portfolios" examined intraday trading for the largest indexed ETFs and found that the ETFs tend to follow the underlying stock as opposed to lead it. "An ETF is more likely to impact its underlying holdings, however, when it is active, concentrated and has high institutional ownership," said Richard B. Evans, associate professor of business administration at University of Virginia's Darden School of Business and one of the paper's authors.
"The big issues all revolve around the liquidity mismatch of the arbitrage," said Dave Nadig, chief investment officer at research firm ETF Flows. "Lost in the shuffle of GameStop trading (by WallStreetBets) was the fact that notional exposure in the implied delta hedges exceeded the capacity of the underlying, causing the wild price movement," said Mr. Nadig. That is, there was limited supply of the stock available for market makers to hedge their risk.
"If I worry about anything, it's probably related to VIX futures where a coordinated 'attack' on a specific contract or underlying options strip could have some interesting consequences," Mr. Nadig said.
In fact, ETPs buying or selling futures on the CBOE Volatility index have already offered several lessons in how a product could become unmanageable due to the challenges of tracking or hedging. Many such products were either closed or had their leverage reduced to avoid those risks. Currently, there are only seven ETPs targeting VIX with $4.8 billion in assets under management, according to ETF.com.
"The very fact that the ETF and the underlying trade separately is a huge buffer," said Mr. Nadig. If there was a run on an ETF, the most a trading mob could hope to achieve would be to "pop a premium. No matter how much you buy, the effect can only be that. The real question is will authorized participants arbitrage out the premium?"
Brokers acting as authorized participants are in a unique position to arbitrage pricing discrepancies between a fund and its underlying assets by exchanging fund shares for underlying assets and vice versa. When an ETP trades at a premium, authorized participants effectively short the ETP and deliver the underlying asset in exchange for newly created shares of the ETP, using those shares to cover the short. When an ETP trades at a discount, the opposite occurs.
"If there are enough active arbitrageurs trying to keep prices in line with fundamentals, you have a stabilizing force that prevents prices from ever going too far from their intrinsic value," said Wesley Gray, CEO of Alpha Architect LLC, which manages $611 million across six ETF strategies. "But that assumes there's still arbitrage capital in the market," said Mr. Gray.
