# Index bubble?



## digitalatlas (Jun 6, 2015)

This article was posted on Yahoo, and among other topics, they discussed how Burry thinks there's a bubble created by the increasing popularity of indexing. I hadn't really thought about this before, but it seems he suggests that (if I'm understanding correctly) that the prices are not reflecting the true value of the underlying equities, but indexes have risen because people keep putting money into it. I can see there being some logic to that. What do you think?

https://finance.yahoo.com/news/big-short-michael-burry-explains-104146627.html


----------



## Topo (Aug 31, 2019)

I am not sure that funds flowing into index funds is any different than funds flowing into single stocks in the market. If the stock market is overvalued or is in a bubble (doubtful), it is not because investors are using index funds. It would be no different than buying single stocks, in aggregate. In a way, inflows to broad-based index funds are neutral, because they are proportional to the weightings of each stock in the market.


----------



## digitalatlas (Jun 6, 2015)

It is the same in principle, you're right. But the size of the cohort of index investors, the historically unprecedented ease of purchasing an index, could potentially influence how much money is flowing into the market, beyond what influence (in the past) a smaller, more knowledgeable group of professional investors may have bought, based on fundamental analysis, could it not? 

I suppose one could try to calculate or estimate what point of intersection that may be, but it would probably be hard with all the variables involved. But that point should exist.

My background is actually in the sciences, and as an example, when we look at nanoparticles on human exposure leading to disease, let's say you take a carbon atom that's not a nanoparticle. It might cause one health effect. Take the same carbon source, but break it up into nanoparticles, and even though it's the same stuff atomically, it behaves differently and can have a different health outcome.


----------



## Topo (Aug 31, 2019)

digitalatlas said:


> It is the same in principle, you're right. But the size of the cohort of index investors, the historically unprecedented ease of purchasing an index, could potentially influence how much money is flowing into the market, beyond what influence (in the past) a smaller, more knowledgeable group of professional investors may have bought, based on fundamental analysis, could it not?


It may be true that there is more money flowing into stocks than the past, but I think this is because money is cheap, we are awash in debt, and there is a perception that stocks are less risky if held for the long term. The intermediary/vehicle probably would not make a major difference. For example, once I decide to invest X amount into stocks, whether I buy a few individual stocks, an index fund, or give it to a fund manager to pick stocks for me, would not be materially different: X amount is flowing into stocks. The "market" is the aggregate of all the participants, whoever they may be or whatever vehicle they use.


----------



## OptsyEagle (Nov 29, 2009)

1st of all. There were a lot more factors to the previous credit crises (unethical mortgage brokers, unethical rating agencies, unethical bankers, unethical brokers and insurance companies that had no idea how to price credit risk...and borrowers who thought they could buy a $750,000 house earning $15,000 per year of annual income) then just the pricing of CDOs, as this individual seems to suggest. 

2ndly, the credit markets, where CDOs existed, were a little more difficult for the average investor and even the more sophisticated, to go to work and analyse. Contrast that to the stock market, where just about everyone can access corporate news and financial reports, etc., and you will see a drastically different market for research.

With all that said, he is correct that index investing can distort the proper price of a security within that index, one needs to keep in mind that there are literally 100s of millions of investors attempting to take advantage of any distortion on any security at any time. Since the analysis of most index securities is much easier then some of the convoluted debt securities that existed during the credit crises, I have full confidence that those investors are quickly correcting any distortions, that index investing might create, long before they get anywhere detrimental.

I would worry when you start to see index investing becoming more then 25% of equity investing. Where 100% of investing incorporates all individual investors as well as institutional, like pension funds, mutual funds, hedge funds, etc. The last time I looked we are still under 10%. I doubt it will get up to 25%, because of our basic greed instinct, within the human mind. Remember, that an index fund will probably be outperformed by 40% of all mutual funds and maybe even more of all individual investors...AT ANY GIVEN TIME (not necessarily long term). Humans hate seeing all these investments outperforming their own, at all given times, so they tend to have this constant aversion to indexing, right up until they start seeing their own results from those alternatives. 

Anyway, we are a long way away from the point that these small distortions will create a serious drag and even when that happens, it will be a small percentage drag, NOT a credit crises type implosion.


----------



## Rusty O'Toole (Feb 1, 2012)

There are a few angles on this. One is that the stock market as a whole has been driven for the last 10 years by massive money printing by central banks, and their zero interest rate policies which forced investors to buy stocks in hope of getting some kind of return, as opposed to bonds which have practically no return, and in some cases negative returns.

Another is that indexing means every stock on the list gets bought willy nilly. So a lot of bad and mediocre companies get bid up for no reason except that they are part of an index.

There is another way to look at it, and that is, that all the ETFs, mutual funds, hedge funds etc are the market. They account for the majority of stocks bought, sold and owned. This is why they fail to beat the market - in aggregate they are the market.

The only way for the boom to crash is if the central banks stop printing money and interest rates rise to more normal levels. But that cannot be allowed to happen because it would crash the world economy and bankrupt every government and large company. All are in debt and all depend on low interest rates to survive. If interest rates went to 5 or 6 percent their payments would double or triple and they don't have the money to pay it.

So, I don't see the investment environment changing any time soon. I agree that fundamentally it is a **** show that would collapse overnight if rational policies were put in place. And that is why rational policies won't be put in place. It's too late to even think about doing so.


----------



## james4beach (Nov 15, 2012)

Here's another article on it: The Big Short’s Michael Burry Explains Why Index Funds Are Like Subprime CDOs

Haven't read it yet, I'll read it when I get a break today. I suspect he's going to say that you pick up a lot of junk in the index, and can do better by stock picking. Basically an argument for active management.


----------



## Topo (Aug 31, 2019)

I don't think buying the index would distort the prices of the constituent stocks. The prices would go up and down, keeping the relative weights constant. If one were to go into the market and buy a stock individually, and in the process bid the price up or down, then the price would be distorted relative to other stocks.

Buying an index is neutral with regards to the weightings of the underlyings. So if I buy SPY, the relative proportions of MSFT, AAPL and AMZN will not changes, but the price of everything in SPY could go up or down, depending on how I bid.


----------



## OptsyEagle (Nov 29, 2009)

The weightings in the index do change as the prices of the underlying stocks change. The exceptions would be equal weight ETFs and the like.

There is a distortion, but nothing that might create a credit crises like implosion. There are too many non-index investors correcting those distortions, everyday, before they get too far out of line.

Now if one could accurately calculate and identify what is a distortion and what is not, then they could take advantage of such a thing. Since most humans will be right on some and wrong on others and will pay fees each time they trade, the index investor will still win out, in my opinion. Even with those little distortions. In other words, it would be better to eliminate the huge distortion that seems to come from being a human being, which is what one can almost do with index investing. 

I imagine the author of that article, with all the fanfare he has received since 2009, including a movie about his endeavours, must have quite the distorted opinion of himself by now. One of these days, that is going to become very costly to him and his investors. He should probably think about index investing.


----------



## andrewf (Mar 1, 2010)

Sounds like a lot of FUD. The best argument that critics have is that index investing in illiquid underlying assets (such as small caps or foreign small caps) could lead to illiquidity in those index funds. Sure. But most assets are invested in liquid assets such as the S&P 500. I fail to see how a period of illiquidity in small-cap funds will cause a collapse. The underlying companies won't go bankrupt due to a short spell of panic selling.

The risk with index investing is that assets get mispriced relative to each other. But that has a natural stabilizer in the form of active investors. I don't think passive investing is at any risk of eating the world, especially for long term investors who would be making up a small share of trading activity besides.


----------



## Topo (Aug 31, 2019)

OptsyEagle said:


> The weightings in the index do change as the prices of the underlying stocks change. The exceptions would be equal weight ETFs and the like.


The weightings change, but not because of index investors buying the index. They change because other investors are buying and selling subsets of the market (or because of buybacks, secondary offerings, etc). This would only apply to a cap-weighted index (such as the S&P500).


----------



## james4beach (Nov 15, 2012)

james4beach said:


> Here's another article on it: The Big Short’s Michael Burry Explains Why Index Funds Are Like Subprime CDOs


I think some of his points are valid, but he's being overly dramatic. The articles are implying some kind of disaster outcome like the total wipe-out in subprime CDOs. That is simply not going to happen with plain vanilla stock index ETFs. With exotic ETFs, yes it will - avoid those.

I think a better phrasing of Burry's argument is: "You're going to get more volatility, and sharper drawdowns, in index funds due to price distortions that are building up from indexing" (my words).

And I agree with this. I think in then next crash or bear market, investors who bought into the idea of indexing without sufficiently appreciating risk will experience sharp drops that they never anticipated. I personally expect another bear market or crash in stocks could take the indexes down 50% to 70%. Since each crash is different and always surprises investors, this could either turn out to be sharper (larger max drawdown) than in the past, or much _faster_ than people anticipate, causing panic.

For example, when I run into a guy in the gym locker room who tells me he's new to investing and is putting all his savings into VGRO (as I did a couple days ago), that's the kind of person who is going to get destroyed in this scenario, and will probably panic sell due to the incredibly sharp % drawdown. These are people who have no idea what they could be in for. When this guy experiences a 60% drawdown in VGRO, he's going to lose his mind. He'll be thinking "this thing was supposed to be diversified! this kind of decline should be impossible! indexing must be broken!"

I think Burry could turn out to be correct that due to major price distortions from indexing, that the index could have these severe drops, whereas stocks from "outside" the index, or a fundamentals-based portfolio, could perform better -- relatively speaking. Another way to describe this would be that we could see indexes like SPY and XIC drop a much larger % than actively managed portfolios that aren't relying on indexing.

If that scenario unfolded, it would make indexing look "broken" for a period of years (due to underperformance). That could be 5 - 10 years ... which is a very long time for investors ... where the index gives the worst results. However, this would not mean indexing is broken. It's just the natural result of very large price swings (overvaluation > mean reversion > undershoot > back to normal)

But that's the worst case outcome that I see from this argument. The indexes won't blow up and become useless. Rather, the investors who rely on indexes get more severe drawdowns, severe volatility, and then lingering underperformance. *Volatility is in fact quite dangerous*, something people don't believe, but due to human psychology and real-life time horizons, I strongly believe that volatility is a very hazardous thing.

He does raise another point though, which is about the structured ETFs which use derivatives techniques to sample and replicate indices, and how hard it will be to unwind or adjust those positions in market turmoil. On this one I agree 100% and humble_pie has been warning about this for some time. The more complex and ambitious ETFs, which supposedly hold huge numbers of stocks, take shortcuts and use alternative techniques to synthetically track indices.

Those kinds of ETFs, of which are there are a ton (including IVV) will probably then underperform their respective indexes.

This is a big reason I continue to like XIU, my favourite Canadian ETF,. This is a true "plain vanilla" ETF, and it only holds 60 stocks. That's important because these are the 60 most liquid stocks in Canada... a tremendously good design choice. It is totally feasible to effectively track and manage funds in & out of 60 of the most liquid large caps. At the danger of speaking for humble_pie, I think she and I agree that it is not feasible to accurately track and manage fund flows for one of these ETFs like VT which supposedly holds 8,202 stocks from around the world, or XAW with 8,653 supposed holdings.

*~~ Summary ~~*

I think indexing is still fine, except we may get severe volatility and huge drawdowns beyond expectations of most investors, due to price distortions we've had in recent years as described by Burry. Personally I'm expecting equity index declines (max drawdown) of 50% to 70%. Volatility is dangerous, so I think it's an important warning. Particularly bad trouble could hit the more exotic ETFs, and structured funds which use derivatives to estimate and mimic various things.

To mitigate these risks, stick to the tried-and-true plain vanilla ETFs, the simpler the better, and be prepared for the possibility of very large % drawdowns in excess of the 2001 and 2008 bear markets.

You might want to avoid the global ETFs which claim to hold huge numbers of foreign stocks. I avoid those. I think they will likely underperform due to some derivative and synthetic replication blowups. I prefer XIU and ZSP (plain vanilla) over XAW, for example.


----------



## john.cray (Dec 7, 2016)

james4beach said:


> He does raise another point though, which is about the structured ETFs which use derivatives techniques to sample and replicate indices, and how hard it will be to unwind or adjust those positions in market turmoil. On this one I agree 100% and humble_pie has been warning about this for some time. The more complex and ambitious ETFs, which supposedly hold huge numbers of stocks, take shortcuts and use alternative techniques to synthetically track indices.


That's one thing that caught my attention in his comments and I immediately remembered what humble_pie has been warning us for some time. Thanks for the reminder.

One question to you and her: How can one tell if an ETF uses derivatives to track an index versus one that doesn't, i.e. strictly holds the underlying stocks directly?
Is looking at the "holdings" section of the ETF's page enough or is there another way?

Is the sheer number of underlying stocks a good indication of derivatives? For example I hold VIU which has 3,722 holdings. In the factsheet it reads:


> Currently, this Vanguard ETF seeks to track the FTSE Developed All Cap ex North America Index (or any successor thereto). It invests directly or indirectly primarily in large-,mid-and small capitalization stocks of companies located in developed markets, excluding the U.S. and Canada.


Is the *indirectly* part referring to using derivatives or simply other ETFs?


----------



## andrewf (Mar 1, 2010)

Can't one look at the creation unit? Ie, the basket of securities that a authorized participant needs to provide in exchange for a set number of units of the ETF? That should be a good guide to what the fund holds, as it also what the fund needs to provide in the case of redemptions. An ETF will run into problems during fund outflows if it does not hold this basket.


----------



## OnlyMyOpinion (Sep 1, 2013)

Just look up the fund prospectus and perhaps some annual reports on SEDAR or the fund site. This should be done before you buy into any fund anyway.


----------



## james4beach (Nov 15, 2012)

john.cray said:


> One question to you and her: How can one tell if an ETF uses derivatives to track an index versus one that doesn't, i.e. strictly holds the underlying stocks directly?
> Is looking at the "holdings" section of the ETF's page enough or is there another way?


I don't know, exactly. humble_pie suspects that regulations don't require complete disclosure on this. She may be right; I don't know enough about securities regulations.

I look at the audited financial statements and take that literally. I see enough things in there to raise my suspicions, as described below.

The holdings web page is not sufficient. You do actually have to look at financial statements. For example, pulling up IVV (the US ishares page, click Annual Report) and browse to page 19, Schedule of Investments, you start to see interesting things:

You will see under several sector categories that they list some stocks, but not all the stocks of the S&P 500. There are many placeholders that say "Other securities", for pretty substantial %s of the ETF. Those are probably derivatives like futures, or who knows what else. Some of them appear like that because the actual stocks are out on loan (securities lending). Many stocks are missing.

There is also a section showing futures contracts. They hold S&P 500 E-mini contracts, so to some extent, IVV is mimicking the S&P 500 using index futures.

Determining the extent of the futures exposure (in lieu of real stocks) is tough to assess. It's hard to understand because the value of the futures usually appears to be tiny. What people forget, though, is that *futures are very highly leveraged*. I don't remember the exact numbers, but it's something like, $10 million in futures is equivalent to $300 million or more in notional exposure.

I think IVV and the other iShares core funds are one example of derivatives infiltrating what should be a simple, plain ETF. And remember that Canada's XUS just is a wrapper around IVV, so you have all the same futures fun.

It's very tricky to dissect actually. I usually look out for any sign of derivatives holdings, and then avoid them. I would not invest in IVV or XUS.

How about Canadian ETFs though? Ugh, I'm not sure. I don't know if disclosure is as good with ours. Let me take a look at XAW. Again, look at the Annual Financial Statements linked at the bottom of the iShares page.

This is one of these "structured products", a wrapper of ETFs. *Personally I do not like all the layers of indirection in these things (wrapping and sub-holdings).*

XAW holds a bunch of other ETFs. It holds XUS which in turn holds IVV, which as discussed above, includes futures contracts (index derivative in lieu of real, individual stocks). So yes, XAW contains some derivatives and index replication techniques.

XAW's next largest position behind XUS (IVV) is XEF. According to this financial statement, it holds a monstrous list of securities in many countries. I don't see any placeholders or explicit derivatives, but then again, this is written according to Canada's securities laws (maybe as humble_pie says, they don't have to disclose replication tools or derivatives). 

XEF really shows a ton of underlying securities. I just have the nagging suspicion that they can't really manage all those positions in all these securities, many of which will have limited liquidity. How could they? It just doesn't seem feasible. Go look at the list yourself. Then look up some of the stocks on European and Asian exchanges ... take a look at how little volume some of them. Random example: accesso Technology Group in the UK. This traded just 7,000 shares in the day in total.

Maybe I'm overly cynical but this just doesn't sound right to me. What happens when $50 million flows into XEF in a single day. Does iShares go out and buy another 3 shares or whatever (odd lot) in a highly illiquid security that only trades 7,000 shares a day?

Think of how big the bid/ask spread must be on something that illiquid. And XEF is moving $ in and out of that, daily? Really?

(a) if they're really doing that, this isn't particularly efficient, and there will absolutely be friction and big losses in market turmoil where lots of $ is pulled out of XEF. This would cause high volume selling on already illiquid securities in a depressed market, causing huge friction and inefficiency

(b) Or, as humble_pie suspects, are they replicating it somehow, and Canada's securities laws doesn't show us the nitty gritty details? This would be more efficient and potentially more desirable, but also gets into games.

At face value, based on what's written here, I don't see any clear signs there is sampling replication, or other derivatives. I don't know if it would show up, though. I have my suspicions. I don't know which I would prefer, (a) or (b) ! Neither is good.



> Is the sheer number of underlying stocks a good indication of derivatives? For example I hold VIU which has 3,722 holdings. In the factsheet it reads:
> Is the *indirectly* part referring to using derivatives or simply other ETFs?


I think that's what the language is referring to. But I don't think so clear, just based on the number of holdings.

Let me see if I can see what this "indirectly" refers to... pulling up financial statement...

There's a statement buried on page 308 which may shed some light on this:



> Additionally, the Funds may use futures contracts to maintain full exposure to the stock market, maintain liquidity and minimize transaction costs. Funds may purchase futures contracts to immediately invest incoming cash in the market, or sell futures in response to cash outflows, thereby simulating a fully invested position in the underlying index while maintaining a cash balance for liquidity.


I do see some evidence of futures existing in many of these funds, but the accounting of it really isn't clear to me. To be honest, I can't tell from these financial statements what's going on.

Here's my guess. VIU, like XEF, shows an absolutely massive listing of individual securities. Tiny holdings (like 233 shares) in some totally illiquid foreign stock. How the heck can this seriously be managed, given that the various shares trade in different time zones, out of sync with Toronto trading. Apparently they are buying 1 share or selling 2 shares here or there in illiquid foreign markets, matching fund inflows/outflows of millions of $ in Toronto. Really?

Maybe that's why the futures are used, replicating index exposure, and then perhaps they wait and group the securities buy/sells into larger blocks (which would be more efficient).

Sorry... no clear answers. With those US funds, it's pretty clear they hold futures, and are doing something else which results in missing securities (could be replication, estimates, securities lending, or futures in lieu of stocks).

With the Canadian funds, it's less clear to me, but the financial statements seem to pretty explicitly state derivatives are used for "simulating a fully invested position".


----------



## james4beach (Nov 15, 2012)

After delving into those examples, I think I now have a better idea of Burry's concerns, and I buy his argument more than I did before.

Those massive listings of tiny stock holdings in thousands of foreign stocks (VIU, XEF, XAW, etc) do really make me scratch my head. Clearly, there will be liquidity concerns here -- which will only appear during market turmoil. None of this comes up during good times.

Most of these ETFs did not exist back in 2008. They have never lived through that kind of market stress. Very important to think about!

There are plenty of signs of index replication using futures to maintain placeholder positions until catch-up stock trades can be made. As Burry says, this really does have a similarity to those mortgage things and structured products of the past crisis:

The index futures are single securities which (in a very abstract way) represent the underlying. They become a thing of their own, with all these funds trading the index futures among themselves.

Those futures get resolved, matched to real stocks at some point. Under normal conditions that is just fine. But under market stress, what happens to all those thinly traded foreign stocks (or thinly traded small and mid caps) with huge bid/ask spreads?

It's a mis-match of markets and liquidity. Very liquid index futures, which will probably diverge significantly from the actual underlying equities, during market crashes.

That's a parallel to baskets of mortgages (indices) which looked fine, until liquidity dried up in the underlying, and then all the structures fell apart. These ETF structures aren't quite as bad, because they do hold underlying equities, but the replicated parts are concerning.

And again, this wasn't tested in 2008. The wrapper-of-wrapper-of-wrapper-with-futures-placeholders things are totally new.

The implication of all this is that due to the friction that results from illiquid underlying, huge bid/ask spreads, and crashing futures trading against illiquid stocks... is that ETFs that contain too many of these replication derivatives may experience some losses (permanently) due to liquidity and tracking issues, that they will not recover when the market bounces back. It's just friction and liquidity related losses.

That will result in underperformance. The index on paper will look fine, and the ETF will do worse. How much worse, no idea!


----------



## Topo (Aug 31, 2019)

The ETF's NAV could for a short time period, due to severe stress or a flash crash, etc, deviate from its true value, but at some point has to reflect its holdings. The same factors would also affect mutual funds, including active ones, so I don't understand why Burry is singling out passive investments. We could have a bubble of the same magnitude if all of us invested the same amount of money in active mutual funds. 

There are decades of experience with mutual funds (including the 1987 crash, flash crashes, etc) and so far in most cases (index or active), there have not been any major problems. ETFs are basically nothing more than a tradeable mutual fund.

The investor could take the possibility of NAV deviations from market price into account and avoid trading ETFs or mutual funds during tumultuous markets. Of course, these times could also provide opportunities for some.

When the Greece problems surfaced a few years ago, the stock market closed for a while and only ETFs tracking Greek equities were trading. When the Greek stock market opened, the stocks traded close to their pricing in the ETF. It seems that freely trading ETFs provide price discovery similar to a functioning market.


----------



## james4beach (Nov 15, 2012)

Topo said:


> There are decades of experience with mutual funds (including the 1987 crash, flash crashes, etc) and so far in most cases (index or active), there have not been any major problems. ETFs are basically nothing more than a tradeable mutual fund.


But I think index futures for providing (artificial) liquidity is the new element. Traditional ETFs did not use them; ETFs are supposed to be baskets of stocks, redeemable and creatable for underlying stocks.

But now, index futures are allowing ETFs to track baskets of _things that are normally not liquid and trackable_, like smaller cap stocks, and foreign stocks.

Even if mutual funds used some futures positions before, they are settled once a day and don't have the same dynamics. An ETF trades continuously through the day, and traders react to the prices. So I really think this might be a brand new thing... futures providing artificial liquidity in real-time, continuously traded funds.


----------



## Topo (Aug 31, 2019)

Security lending, it seems to me, is the Achilles Heal of these structures. It is common practice with most mutual funds and ETFs, and it introduces counterparty risk which will show up at exactly the wrong time. This is not unique to ETFs; brokerages lend stocks from personal margin accounts, which could be as much risky as when an ETF does this. This is not unique to passive funds though. Any XYZ held in a margin account has this risk.


----------



## andrewf (Mar 1, 2010)

James, the ETF provider is not responsible for trading the shall illiquid holdings resulting from fund inflows and outflows. That is the Authorized Participants who make the market in the ETF or arbitrage the market price and NAV. APs have to deliver actual shares, whether they own them or borrow them. And the redemption units mean the ETF has to be able to deliver actual shares and not derivatives. I think it is unlikely that ETFs are using as much undisclosed derivative replication as you fear. It would mean the ETF having to sell small numbers of illiquid holdings received through creation units in order to buy derivative exposure. 

For international ETFs, the ETF itself doesn't have to trade to create or redeem units, that is what market makers are for. Typically these types of funds have higher spreads to compensate the APs for the added difficulty of trading these positions. And spreads are only a problem if you are trading, not holding. 

I still don't get how the comparison to CDOs is appropriate. Seems like extremely irresponsible FUD. How could ETFs become worthless independent of the underlying? James, you are talking about a tracking error, and likely a small one.


----------



## humble_pie (Jun 7, 2009)

john.cray said:


> That's one thing that caught my attention in his comments and I immediately remembered what humble_pie has been warning us for some time. Thanks for the reminder.
> 
> One question to you and her: How can one tell if an ETF uses derivatives to track an index versus one that doesn't, i.e. strictly holds the underlying stocks directly?
> Is looking at the "holdings" section of the ETF's page enough or is there another way?



looking at the "holdings" list is neither accurate nor cleanly helpful imho. Evidently the regulators in both canada & the US permit ETF vendors to hold unnamed representational stocks & unnamed derivative products while publishing the list of the stocks they are supposed to be tracking as their "holdings."

no wonder the public believes that these ETFs actually do "hold" the named securities. 

we should remember that finance is a self-regulating industry. There is no reason for regulators to arbitrarily increase the number of regulations a financial product vendor must comply with, unless consumers are bombarding the regulators with requests/demands for more information, which is not happening with ETF transparency, at least not yet.

as with fund trailer fees, disclosure of hidden information is only going to come after many years of complaints from consumers to the regulators. It took more than 20 years of steady complaints & steady work by financial consumer organizations such as Fair Canada to persuade the IIROC to require better trailer fee disclosure.

right now, consumers are pecking away at the authorities to be more transparent in disclosing their foreign exchange fees. This is having some success as new products with reduced FX fees debut, or as FX-avoidance mechanisms become known to retail investors/credit card holders via forums such as CMF.

but what i believe is widespread use by ETF managers of derivatives & synthetic products to replicate stock market performance is still an unknown space frontier. It's Star Wars for a lone journo like hubbity pie (originally my CMF teammate in the derivative ETF chronicles was haroldCrump; however harold has had to depart social media like this forum in order to seriously pursue Important Career Opportunity)

still, i'm happy to see that, little by little, one nano-step at a time, evidence keeps emerging that all is not quite kosher in ETFland.

for the record, might i say i have nothing against ETF vendors cutting their costs to the bone by holding low-cost Solactive indexes or other derivative products in lieu of actual stocks. What i profoundly object to is the widespread practice of hoodwinking millions upon millions of investors into thinking that their vegetable soup ETF - a vehicle allegedly holding 2000, 3000 or 4000 global stocks sprinkled across 30 or 40 global stock exchanges, some notoriously corrupt & difficult to deal in - the entire universe of stocks being cheaply bought, sold, flipped & re-balanced on a daily or weekly basis, almost without cost - most ETF investors still believe that the stocks which regulators permit a fund company to declare they are holding, are indeed on hand in any kind of safe custody.

the prospectuses will always state, when applicable, that such ETF engages in representational trading, also it trades futures, swap contracts, options & other derivatives, also it lends out some of its stock holdings to hedge funds in order to earn the fees it requires to exist, given its low MER fees.

the puzzling thing is that the financial statements never show those atypical, aberrant or anomalous positions. Something is going wrong here. Meanwhile the fact sheet summaries are allowed to list the stocks such ETF is tracking as its "holdings." It's the widespread dishonesty that bothers me.


.


----------



## john.cray (Dec 7, 2016)

humble_pie said:


> looking at the "holdings" list is neither accurate nor cleanly helpful imho. Evidently the regulators in both canada & the US permit ETF vendors to hold unnamed representational stocks & unnamed derivative products while publishing the list of the stocks they are supposed to be tracking as their "holdings."
> no wonder the public believes that these ETFs actually do "hold" the named securities.


Thanks. That's what I figured and as James pointed out there are a few pointers to look at.
Have you found any [other] ways to find out the content of derivatives held in an ETF? 
Maybe if you have it handy you could give an example of a "clean" ETF with no shenanigans as well as the opposite case. I would appreciate it.

Cheers


----------



## kcowan (Jul 1, 2010)

humble_pie said:


> ...the puzzling thing is that the financial statements never show those atypical, aberrant or anomalous positions. Something is going wrong here. Meanwhile the fact sheet summaries are allowed to list the stocks such ETF is tracking as its "holdings." It's the widespread dishonesty that bothers me...


Yes I see that many people evaluating ETFs are being mislead by the documents. It seems that the only way to evaluate an ETF is by the reputation of the company and tracking error and history of the specific ETF?

Do you think Solactive qualifies by your standards?


----------



## humble_pie (Jun 7, 2009)

john.cray said:


> Thanks. That's what I figured and as James pointed out there are a few pointers to look at.
> Have you found any [other] ways to find out the content of derivatives held in an ETF?
> Maybe if you have it handy you could give an example of a "clean" ETF with no shenanigans as well as the opposite case. I would appreciate it.




this is a gigantic story, a huge hydra-headed scandal that will require an army of journos plus very many years to unravel. As i just mentioned a post or 2 ago, north america is nowhere near ready to take on this monster.

why would you think that fund managers at the highest level will ever gladly admit that they've been misleading all their clients all these years? to the contrary, masking the truth is the one thing they will fight hardest to maintain.

the only force that could break the ETF industry's silence would be a massive & sustained outcry from consumers. There is zero sign that anything like this is currently underway.

PS i don't believe any "clean" ETF exists. It's impossible to run any kind of business on a margin of one-half of one percent profit, most investors ought to know that. Certainly not any kind of complicated business where the inventory is spread out across 30 or 40 different global markets & nearly all of the inventory is allegedly being bought, sold, traded & re-balanced on a weekly if not a daily basis.

as mentioned, i'm not against representational trading even if it means swapping derivative products. What i do question is failure/refusal to inform a client properly.


----------



## james4beach (Nov 15, 2012)

I share humble_pie's suspicions. In yesterday's adventures through financial statements, I saw various inconsistencies, such as the income statements showing gain/loss from futures contracts, even in ETFs that don't show any futures positions. Clearly they had traded them some time during the year, but did not show them on the books at year end.

Not to mention the blazingly clear statement on page 308 of one of Vanguard's statements which said: "Additionally, the Funds may use futures contracts to maintain full exposure to the stock market, maintain liquidity and minimize transaction costs. Funds may purchase futures contracts to immediately invest incoming cash in the market, or sell futures in response to cash outflows, thereby simulating a fully invested position in the underlying index while maintaining a cash balance for liquidity."

So yes, there are things going on in these funds which aren't well disclosed. I can't tell if it all revolves around securities lending, or what. But there are derivative positions in these things which are not fully and transparently disclosed.



andrewf said:


> James, the ETF provider is not responsible for trading the shall illiquid holdings resulting from fund inflows and outflows. That is the Authorized Participants who make the market in the ETF or arbitrage the market price and NAV. APs have to deliver actual shares, whether they own them or borrow them. And the redemption units mean the ETF has to be able to deliver actual shares and not derivatives. I think it is unlikely that ETFs are using as much undisclosed derivative replication as you fear. It would mean the ETF having to sell small numbers of illiquid holdings received through creation units in order to buy derivative exposure.


Ok, so the inflows or outflows get handled by APs and involve actual stocks - that is good. But still, derivatives for replication of the intended exposure are popping up at some point, e.g. Vanguard's statement I posted above, and the clear use of derivatives in IVV and the "missing" stocks from the S&P 500. Who knows, perhaps they're lending out tons of the funds after the stocks are acquired, and that's where the derivatives come into play?

If shares of IVV are created and redeemed perfectly with the underlying stocks, at what point do so many of their stocks go missing, and get replaced with derivatives? It's obviously happening at some point.

Notice Vanguard's language about using futures to *minimize transaction costs*. So indeed, the derivatives are being used in lieu of real stock transactions at some point in the process.

I agree with you that it ends up as tracking error in the end. In the worst cases, these ETFs won't crumble and go to zero. They may just underperform the index, or their price/NAV might diverge from the index (perhaps by several percent) during a period of market stress. Mind you, if market stress lasts for months or years, that wouldn't be pleasant for investors holding it.


----------



## OnlyMyOpinion (Sep 1, 2013)

Interesting thread. Vanguard is perhaps the most transparent etf provider because of their structure. As Humble noted, one needs to understand the differences between US and CDN regulations/what is allowed.
It remains difficult to actually quantify the extent of derivatives use. *You pretty well have to accept their use and have confidence in the provider of the etf, or buy your own individual stocks.*

https://advisors.vanguard.com/VGApp/iip/site/advisor/etfcenter/article/ETF_PhysicalSynthetic
_*Physical* ETFs attempt to track their target indexes by holding all, or a representative sample, of the underlying securities that make up the index. For example, if you invest in an S&P 500 ETF, you own each of the 500 securities represented in the S&P 500 Index, or some subset of them. Physical replication is reasonably straightforward and transparent. Nearly all ETF products in the United States are physical ETFs. 
Physical ETFs have demonstrated a strong capability to provide low-cost access—with low tracking error—to many broad-based indexes, suggesting that investors often may not need to take on the increased counterparty risk of synthetic ETFs.

Though some *synthetic* ETFs are available in the United States, they are most popular in Europe, where they were introduced in 2001. Like their physical cousins, synthetic ETFs are designed to track a particular index. However, the synthetic ETF replication process is quite different. Instead of physically holding each of the securities in its index, a synthetic ETF relies on derivatives such as swaps to execute its investment strategy.
These derivative vehicles are agreements between the ETF and a counterparty—usually an investment bank—to pay the ETF the return of its index. In essence, a synthetic ETF can track an index without actually owning any of its securities.
Because they don't physically hold the securities in which they invest, synthetic ETFs can provide a competitive offering for investors seeking to invest in harder-to-access markets, less liquid benchmarks, or other difficult-to-implement strategies that would otherwise be very costly and difficult for physical ETFs to track.
The chief risk of synthetic ETFs is counterparty risk. Essentially, synthetic ETF investors trust that the total-return swap provider will carry through on its obligation to pay the agreed-upon index return. If that does not happen, investors risk incurring a loss. The key risk mitigator in the event of a counterparty default is collateral._

On the other hand, from the  VTI prospectus_ (US-based Total World Stock Etf): The Fund may invest, to a limited extent, in equity futures and options contracts, warrants, convertible securities, and swap agreements, all of which are types of derivatives. Generally speaking, a derivative is a financial contract whose value is based on the value of a financial asset (such as a stock, a bond, or a currency), a physical asset (such as gold, oil, or wheat), a market index, or a reference rate.
Investments in derivatives may subject the Fund to risks different from, and possibly greater than, those of investments directly in the underlying securities or assets. The Fund will not use derivatives for speculation or for the purpose of leveraging (magnifying) investment returns._

The  prospectus for the popular Cdn-based VBAL, VGRO, VCNS family of etfs says, _Use of Derivative Instruments - Each of the Vanguard ETFs may invest in or use derivative instruments, including options, swaps, futures contracts and forward contracts, from time to time for hedging or non-hedging purposes provided that the use of such derivative instruments is in compliance with NI 81-102 and is consistent with the investment objective and strategy of the Vanguard ETF. See “Investment Strategies – Use of Derivative Instruments”._

Good discussion  here: _First, he (Spencer Mindlin, Aite Group) explained that ETFs are not like mortgage-backed securities. ETFs are transparent, and regardless of the replication model, an ETF’s exposure is ultimately backstopped by an instrument that provides that exposure.
“For sure, an ETF’s use of use of derivatives can introduce additional risks, such as counterparty risk. But it’s incumbent on the investor to know what they’re buying and the risks associated,” he explained. “This can be helped by continual investor education, investor suitability screens, and industry coordination and adoption of a standard categorization and labeling approach to ETPs.”_

On the other hand, if you are into losing sleep, a different concern about etfs is expressed here  Hidden power of the Big Three? Passive index funds,re-concentration of corporate ownership, and new financial risk.


----------



## james4beach (Nov 15, 2012)

After I discovered how much securities lending these providers do, I did lose some trust in the ETF providers, and that's a big reason I hold some individual stocks and bonds.

That being said, our own brokerages also lend out our shares (especially if you have a margin account!) so there's probably no escaping all of this in the end.

Re the quote "explained that ETFs are not like mortgage-backed securities" ... this is not what Burry was referring to recently. He criticized the index ETFs for being a single, abstracted trading vehicle which represents all the underlying, such that you blindly buy & sell the whole basket without regard to details of the underlying. He said this transformation of varied & complex equity markets into a single vehicle distorts pricing in the stock market.

Basically, everyone just 'buys the market' or 'sells the market'. I continue to worry about the day that every bot and algorithm on earth decides it's time to 'sell the market'... it will make everything go down, very fast, whether or not the stock trades at fair value or not. That part of Burry's criticism has nothing to do with ETF derivatives.


----------



## humble_pie (Jun 7, 2009)

OnlyMyOpinion said:


> Interesting thread. Vanguard is perhaps the most transparent etf provider because of their structure. As Humble noted, one needs to understand the differences between US and CDN regulations/what is allowed.
> It remains difficult to actually quantify the extent of derivatives use. *You pretty well have to accept their use and have confidence in the provider of the etf, or buy your own individual stocks.*
> 
> https://advisors.vanguard.com/VGApp/iip/site/advisor/etfcenter/article/ETF_PhysicalSynthetic
> ...




actually i find vanguard to be among the less transparent, in part because of its excessive virtue signalling, how it's such a boy-scout's-honour-investor-owned entity et patati et patata.

few years ago haroldCrump said that vanguard & ETFs in general were no longer what john bogle had had in mind when he founded the industry so many years ago. Not long after harold's prophecy - shortly before bogle would pass away in fact - bogle would publicly disapprove of some of the new bespoke custom-indexed ETFs.

me i'm just a poor pantry biscuit but i don't believe that vanguard morality bumphf about how _they_ have synthetic ETFs that use derivatives over in europe but _we_ have self-righteous whole grain ETFs here in north america that own their stocks outright.

to me, every single position that represents something else - whether the proxy is a derivative or a strategy combination or another stock - is a synthetic position. And i continue to believe that north american ETF companies are utilizing custom-built index modalities, ie derivative or syntheic positons, because these are the only way an ETF can get its costs down.

.


----------



## Topo (Aug 31, 2019)

For replication ETFs or mutual funds, the futures contracts are a small portion of the assets. If they represent 2% of the fund and they are somehow mis-priced or go to zero, it is still a rounding error. 

Futures contracts have been around for a long time. All the S&P500 futures stipulate is that a basket of stocks is delivered at expiration. It is certainly easier than 1000 barrels of oil or so many bushels of corn.


----------



## andrewf (Mar 1, 2010)

My understanding of replication is that an ETF may be tracking an index of many thousands of stocks, but only select a subset to hold that it feels is representative of the index. Because the replication is imperfect, there is a risk of tracking error, but that can be to the positive as well as negative. I can see an ETF also using derivatives to effectively invest cash holdings that are awaiting distribution to avoid cash drag. I'm not saying that there are not any activities that ETFs engage in that should be better disclosed. I think that it is generally less nefarious than people think.


----------



## Topo (Aug 31, 2019)

andrewf said:


> My understanding of replication is that an ETF may be tracking an index of many thousands of stocks, but only select a subset to hold that it feels is representative of the index. Because the replication is imperfect, there is a risk of tracking error, but that can be to the positive as well as negative. I can see an ETF also using derivatives to effectively invest cash holdings that are awaiting distribution to avoid cash drag. I'm not saying that there are not any activities that ETFs engage in that should be better disclosed. I think that it is generally less nefarious than people think.


Agree. The replication process is mostly used for small cap or micro cap stocks which are less liquid and cannot be traded in big chunks without price impact.

There are indices that are easy to replicate. For example an investor with $100,000 or more, could open a cash account and choose to replicate XIU or XIC by buying 20-30 stocks of the S&P/TSX60 and then maybe add another 10 or 20 of the midcaps and small caps. Keeping the account below the 1m threshold would ensure SIPC coverage. 

For the US, a bigger account would be more efficient (eg 500k); one could buy 50 stocks from the S&P 500 or just equal weight the Dow 30. International and emerging markets would be more challenging to replicate.


----------



## james4beach (Nov 15, 2012)

I should scale back some of the concerns I've voiced. As someone who's really interested in the mechanics of these things, I am intrigued by what goes on under the hood of the ETF. And I love good disclosure and transparency. The murkiness in ETFs (and mutual funds) makes me uneasy.

That being said, in practice, I think an investor is better off with index ETFs than a managed mutual fund or other managed portfolio. These things are all relative... and ETFs are a clear improvement. Even if they use some futures and other sampling shortcuts.

The only thing I think _might_ be better than an index ETF is a solid portfolio of large cap stocks, consistently managed according to a plan. And even here I wouldn't say it's better in all cases (certainly not appropriate for a hands-off investor who doesn't want to bother with management). But I do put my money where my mouth is. Nearly all my Canadian stock exposure is with a 5-pack that holds some of the biggest weights of the TSX 60.

And along the lines of Burry's warning, I think that index fund inflows & outflows now move the entire stock market, and the indices could tank a lot more than people expect if money is rapidly yanked. I expect 50% to 70% maximum drawdown in another crash, but I also think there's no escaping it (ETF vs individual stocks).


----------



## Topo (Aug 31, 2019)

I use ETFs for my global stock exposure, but for bonds (all Canadas) I buy them directly, as diversification is less important. If the ETFs falter, the bonds will not be affected.


----------



## Retired Peasant (Apr 22, 2013)

james4beach said:


> ...blazingly clear statement ...
> ...aren't well disclosed...


So which is it?


----------



## james4beach (Nov 15, 2012)

Topo said:


> I use ETFs for my global stock exposure, but for bonds (all Canadas) I buy them directly, as diversification is less important. If the ETFs falter, the bonds will not be affected.


Same here. I hold some XBB in my RRSP, but the majority of my Canadian fixed income is with individual bonds and GICs in a non-margin, cash only account. I suspect this is a wee bit safer than a bond ETF.


----------



## james4beach (Nov 15, 2012)

Retired Peasant said:


> So which is it?


Vanguard makes a clear statement that they use derivatives, see the direct quote. This indicates their general policy on futures & derivatives.

The details of their derivatives are not well disclosed.


----------



## andrewf (Mar 1, 2010)

I can imagine most ETFs saying that they reserve the right to utilize derivatives, etc in their prospectus while in practice seldom or never doing so. Included in the boilerplate by legal.


----------



## kcowan (Jul 1, 2010)

humble_pie said:


> to me, every single position that represents something else - whether the proxy is a derivative or a strategy combination or another stock - is a synthetic position. And i continue to believe that north american ETF companies are utilizing custom-built index modalities, ie derivative or syntheic positons, because these are the only way an ETF can get its costs down...


I think that is the biggest revelation. ETFs are actively traded using derivatives and synthetic positions to keep their costs down. So the investor must decide on an ETF based upon the reputation and history of the company (e.g. VBAL) rather than making any assessment on the "holdings". I concluded that Solactive was a good choice for TD and voted Yes.


----------



## humble_pie (Jun 7, 2009)

kcowan said:


> I think that is the biggest revelation. ETFs are actively traded using derivatives and synthetic positions to keep their costs down. So the investor must decide on an ETF based upon the reputation and history of the company.



pretty much. After all, when we deposit $1,000 in the neighbourhood bank branch, we know that the managers don't immediately install 500 toonies in the basement vault for safekeeping until we ask for our money back. No, they whisk our funds away & lend them out to countless other parties in loan structures so complex that nobody can understand them.

same thing with the ETFs imho, except ETFs are far less regulated & have far briefer & less august histories than the venerable banks themselves. Still, we are willing to give ETFs our money because, when they say they are going to give us the return of such-&-such an index, we believe them.


----------



## humble_pie (Jun 7, 2009)

michael burry puts his finger on the principal risk for derivative-owning ETFs. It'll be the impossibility of unwinding the positions if anything like a global financial collapse occurs, he says.

here's what burry told bloomberg on 3 september 2019:



> Potentially making it worse will be the impossibility of unwinding the derivatives and naked buy/sell strategies used to help so many of these funds pseudo-match flows and prices each and every day.


if global investors were to start stampeding for exit doors, the first to go down would be some counterparties to futures & swap contracts, since there are no guarantors.

contrary to some professional belief, i for one don't believe the public options exchanges would survive very long either. Although options exchanges themselves do guarantee the validity of each & every option contract that's open on their exchange, nevertheless they are 100% dependent on the brokers who have given them the business in the first place.

if several brokers go down in a global financial collapse, they will take all their option positions with them. This is regardless of whether or not an individual client of an insolvent broker would still be solvent. If an individual broker goes down, all of its business & all of its option positions on behalf of all of its clients go down as well.

let several important brokers go down & IMHO one or more or all of the options exchanges would have to close. All option positions would freeze. It would become impossible to unwind anything.

that, in turn, would spell the end for ETFs holding significant derivative positions, Which, imho, most of them do.

in my opinion, armageddon would be worse for any institution or individual with derivatives positions than than it would be for an institution or individual holding plain stock, due to early shutdowns in derivatives markets.


----------



## andrewf (Mar 1, 2010)

But there is a decided lack of ETFs blowing up, or even exhibiting unusual tracking errors. The only ones I am familiar with were obvious and well know risks like leveraged index futures funds. It could be that a downturn will cause enough stress to uncover issues, but ETFs made it through 2008 without issue. Unless all the nefarious activity crept in since then? Even still, I think we need to keep the risks in perspective and not chase casual observers into the safe arms of a 2.5% MER investors group active bond mutual fund.


----------



## like_to_retire (Oct 9, 2016)

humble_pie said:


> Still, we are willing to give ETFs our money because, when they say they are going to give us the return of such-&-such an index, we believe them.


Should we not?

ltr


----------



## humble_pie (Jun 7, 2009)

andrewf said:


> I think we need to keep the risks in perspective and not chase casual observers into the safe arms of a 2.5% MER investors group active bond mutual fund.



the risks are *not* in perspective because they are not even seen, let alone understood.

the problem is worsened by legions of insurance-salesmen-transmogrified-into-financial-planners all selling ETFs as totally "safe," "guaranteed," & "scientific" investment products.

risk cannot even begin to be quantified until the ETF vendors become infinitely more transparent about their actual holdings & about their securities lending practices.

.


----------



## james4beach (Nov 15, 2012)

andrewf said:


> But there is a decided lack of ETFs blowing up, or even exhibiting unusual tracking errors . . . Unless all the nefarious activity crept in since then?


That's a good point. Plain vanilla ETFs were fine through that crisis. Then again, each crisis bring new surprises with it, and bear markets are never the same. We also didn't see securities lending blow up in 2008 (other than a couple small examples) but securities lending is still a real concern.

ETFs are still better than most high MER / actively managed funds, but I do think their benefits have been over-hyped.

The part of Burry's warning that I take more seriously is about the price distortions in the current market, fuelled by indexing. Everyone blindly buying various indices and their constituent stocks purely because of inflows (and printed money). I suspect he's right about this issue, and when the money flows out, it could cause more volatility and larger % drawdowns than people expect.

Especially in foreign markets, where liquidity will be poor in the forced selling driven by index outflows. ETFs have created the perception that "global investing" is much easier than it really is. These problems only become visible in bear markets.


----------



## lonewolf :) (Sep 13, 2016)

digitalatlas said:


> a smaller, more knowledgeable group of professional investors may have bought, based on fundamental analysis, could it not?


 A smaller more knowledgeable a group of investors I would think were the technicians not the fundamentalists.


----------



## MarcoE (May 3, 2018)

Don't ETFs, for all their popularity, just represent a small percentage of equity ownership overall? Could they really rock the boat so much? Maybe the stock market is in a bubble. I don't know. But wouldn't that be more because of low interest rates, less because a bunch of people are switching from actively managed funds to index funds?


----------



## doctrine (Sep 30, 2011)

ETFs are something like 2% of worldwide equities. It's pretty small, and the volume is even smaller. Everything is still being driven actively. I find them incredibly useful, especially for unhedged and cheap exposure to the S&P 500.


----------



## lonewolf :) (Sep 13, 2016)

It as an asset bubble. Though real state, bonds & gold have probably topped & stocks should top shortly


----------



## Topo (Aug 31, 2019)

lonewolf :) said:


> It as an asset bubble.


This is a fair point. Low interest rates for so long have inflated the prices of all assets. ETFs and mutual funds are not the cause, just the vehicles.


----------



## lonewolf :) (Sep 13, 2016)

Topo said:


> This is a fair point. Low interest rates for so long have inflated the prices of all assets. ETFs and mutual funds are not the cause, just the vehicles.


 It is just the cycles regardless of interest rates. The Fed just follows the 3 month T bill rate. Low interest rates never inflated the Japanese stock market.


----------



## james4beach (Nov 15, 2012)

I took a look at Vanguard VT, which is a huge fund of "everything in the world" with supposedly over 8,000 stock holdings in many countries... I wanted to see what kind of derivatives, sampling or replication they might be using.
https://personal.vanguard.com/us/fa...WinJSP.jsp?fundId=3141&isReqFromProducts=true

In the annual report, a large number of the stock holdings are marked as "partial security positions on loan to broker-dealers". Additionally, VT holds index futures such as (these are just a few): E-mini S&P 500 Index, FTSE 100 Index, S&P TSX 60 Index

Their futures positions are about 1% of the fund. Some of the stocks they hold are pledged as collateral (initial margin) requirement to the clearinghouse. But the fund does still appear to be mostly equities, and only a small amount of derivatives.

Still, I'm not very enthused by all this complexity. An ETF is supposed to be a portfolio of equity holdings. Instead, these have become complex financial structures which mix individual stocks and derivatives, also lending out significant numbers of holdings to third parties. Much of this is buried in tiny notes within the financial statements.


----------



## Topo (Aug 31, 2019)

james4beach said:


> I took a look at Vanguard VT, which is a huge fund of "everything in the world" with supposedly over 8,000 stock holdings in many countries... I wanted to see what kind of derivatives, sampling or replication they might be using.
> https://personal.vanguard.com/us/fa...WinJSP.jsp?fundId=3141&isReqFromProducts=true
> 
> In the annual report, a large number of the stock holdings are marked as "partial security positions on loan to broker-dealers". Additionally, VT holds index futures such as (these are just a few): E-mini S&P 500 Index, FTSE 100 Index, S&P TSX 60 Index
> ...



Mutual funds often use futures to fine tune their exposure based on inflows and outflows. The futures are liquid and trade after market. Given that they state in their filings that these instruments are not used for leverage or speculation, there is little risk to the fund. Even if a 1% position blows up every 10 years or so, that shaves off 0.1% from the returns. I don't know of any major index fund getting into trouble with this. Most index funds' tracking error is very close to their expense ratio.

The securities lending is a bit more risky, not knowing who is on the other side of the trade and how leveraged they are. The reason it is so common practice with the funds is that it helps offset some of the expenses, reducing the MERs. There is big time competition among the funds to show a lower MER.

Perhaps it is time for a mutual fund that charges a reasonable MER and avoids futures and securities lending. However, I'm not sure it would meet much success, given most investors are not aware of or don't care about the inner workings of the index funds.


----------



## MrMatt (Dec 21, 2011)

Topo said:


> Mutual funds often use futures to fine tune their exposure based on inflows and outflows. The futures are liquid and trade after market. Given that they state in their filings that these instruments are not used for leverage or speculation, there is little risk to the fund. Even if a 1% position blows up every 10 years or so, that shaves off 0.1% from the returns. I don't know of any major index fund getting into trouble with this. Most index funds' tracking error is very close to their expense ratio.
> 
> The securities lending is a bit more risky, not knowing who is on the other side of the trade and how leveraged they are. The reason it is so common practice with the funds is that it helps offset some of the expenses, reducing the MERs. There is big time competition among the funds to show a lower MER.
> 
> Perhaps it is time for a mutual fund that charges a reasonable MER and avoids futures and securities lending. However, I'm not sure it would meet much success, given most investors are not aware of or don't care about the inner workings of the index funds.


Look at XIU vs HXT.
due to the instruments the MER is a bit lower with HXT, but of course you have that additional risk.
The result is that over 5 years, HXT returned 0.14% more annualized, or about 0.84% over that term.

XIU is more than 4 times as large as HXT.


----------



## Topo (Aug 31, 2019)

Just came across a video by Ben Felix regarding the same subject:

https://www.youtube.com/watch?v=Wv0pJh8mFk0

He argues that the concerns (with regards to index fund bubbles) are overblown.


----------



## MrMatt (Dec 21, 2011)

Realistically, if you're properly diversified a major pop to even the index shouldn't be a big deal.
If it is so bad that the actual fundamentals of those companies change, the economy is in horrible shape and all equities would drop. (otherwise it's a bad/nonrepresentative index)

Even so, that's what diversification across asset classes is meant for.


----------



## james4beach (Nov 15, 2012)

MrMatt said:


> Realistically, if you're properly diversified a major pop to even the index shouldn't be a big deal.
> . . .
> Even so, that's what diversification across asset classes is meant for.


I agree. Even if there's a securities lending blowup in one ETF you hold, with sufficient diversification and multiple asset classes, it shouldn't hurt you too badly.

I just don't like all this complexity with modern day ETFs.


----------



## MrMatt (Dec 21, 2011)

james4beach said:


> I just don't like all this complexity with modern day ETFs.


Then don't buy those ones.
The big ones use a bit of fancy stuff, for cost savings and liquidity etc. But they're mostly holding the assets themselves, because most customers still want that.


----------



## james4beach (Nov 15, 2012)

Yeah, I avoid the more complex ETFs. This is a reason I'm sticking with the plain vanilla domestic index ETFs (like S&P 500 and TSX) instead of the all-in-one global funds such as XAW.

I realize that mutual funds also use things like futures contracts. But I think there's an important fundamental point here worth thinking about. The whole purpose of the ETF structure is to provide a basket of stocks with high *transparency*, to facilitate arbitrage in the marketplace.

Each one of these little tricks, such as adding derivatives, securities lending, and index sampling takes away from that transparency. You are _supposed_ to be able to glance at an ETF and immediately know what it holds -- that's a fundamental feature that keeps them liquid, and keeps the tracking accurate even during market stress and turmoil.

Personally, I don't think there's enough transparency in the giant globe-spanning funds such as VT and XAW. For me, there are too many questions about what exactly they hold. I'm not convinced they can reliably provide sufficient liquidity and price transparency while holding something like 8,000 stocks in many illiquid foreign markets -- just doesn't make sense.


----------



## hfp75 (Mar 15, 2018)

Reality,

I think lots of MF/ETFs buy swaps/derivatives, or borrow stock, ect ect to fulfill investment commitments. If we knew what was really going on we'd be amazed. 

I know right now Horizons is in the cross hairs but in reality the whole industry is a part of this practice (I dont know if one is better than another), and we know lots of MFs are basically just closet indexes. 

When in doubt investors should just buy the S&P / TSX - thats the whole potato strategy, and for the large funds, in a pinch they might buy from Horizons to fill space until they can make other arrangements......

Is there an index bubble, quite possibly, but there is so much money in this game that it wont pop but if it does it'll be catastrophic. (IMHO)

I do agree that there are shitty companies that are a part of the S&P and in reality they should not be. Due to being a part of the S&P it is holding up some stock values. So in this light, there indeed could be some drops or corrections of the dead weight, but it wont happen until the S&P adjusts the holdings matrix.

I like indexes, but I have leaned a bit more on Mawers active management in light of the current economic situation.....


----------



## james4beach (Nov 15, 2012)

I actually think the exotic/derivative problems are separate from the 'indexing bubble' issue. Leaving aside the derivative stuff for a moment:

I'm not sure I'd call it a bubble in indexing, but in recent years people have sure put a lot of faith into indexing. This has led people to buy things indiscriminately, without concern for price or valuation. IMO, this behaviour has inflated equity prices for stocks in the big indexes, especially the S&P 500.

So what? I don't think it's a big deal really. I just think that when the money flows reverse, that the index will probably fall more than people expect is possible. Just as money indiscriminately went in, the money can indiscriminately go out. Not the end of the world, and no big deal to seasoned investors, but I wouldn't be surprised to see 50% to 70% drop as this shakes out.

For example, in 1999, tons of money poured into the NASDAQ because people were super-keen about tech stocks and had no fear of losses. Today, tons of money pours into the S&P 500 index because people are super-keen on the power of indexing and have no fear of losses.

It's just the popular theme of the day, leading to overvaluation. A pretty classic story.

And that doesn't mean that index investing is broken or that it won't keep working.


----------



## andrewf (Mar 1, 2010)

I don't think passive/index investing is driving asset prices, as it still represents fairly little in the way of total AUM. I think lofty equity valuations is more driven by very low discount rates.

50-70% equity price declines are not unusual, and if another one happens, I don't think you will be able to say it was due to passive index investing. Particularly since passive investors are, I'd wager, more likely to hold through price declines as they would be less likely to fixate on asset returns (set it and forget it).


----------



## MrMatt (Dec 21, 2011)

Just thoughts on the market vs individual circumstances. 

Lets assume that the market is efficient and everything has the appropriate risk adjusted price. Implied in this is a certain amount of risk/time horizon.
There may be long time horizon, or very risky stocks that don't align with your personal investment goals.

Just because the market decides that for a specific stock, the extra risk, or 2x time horizon is worth an extra 0.2% in anticipated return does not mean that you share that view, maybe you weigh risk or time differently. Maybe you have a different discount rate.
Repeat for several stocks, or a large portion of a sector, or even the market as a whole, and maybe the "efficient and correct" market price is wrong for you.

Sure the market is getting frothy, and still assuming the market is "efficient and right", it might not match with your goals.

I think this is where making changes, ie different asset allocations, active management etc can make sense.


----------



## james4beach (Nov 15, 2012)

It might not be correct to say there is a "bubble in index investing" but I think what is clear is that index investing is changing the dynamics of the stock market overall. For one, it makes all of us less sensitive to prices and over-valuation (this has already happened).

The stock market is a human system that is constantly changing. The growth of index investing is now again changing the stock market, which mean's today's stock market is different than the historical stock market.

https://finance.yahoo.com/news/index-fund-giants-draw-antitrust-110000658.html



> Behind the scrutiny lies growing worries about the power of giant money managers such as BlackRock Inc., Vanguard Group Inc. and State Street Corp.
> 
> Those fund companies are often called the Big Three because they are the largest index-fund companies and also the largest owners of many U.S. publicly traded firms. Economists and antitrust lawyers are raising concerns that the fund houses are harming competition among the companies whose shares they jointly own.
> . . .
> ...


These are potentially large concerns. Because of fee reduction and growth of indexing popularity, the dynamics of the stock market are changing. There is currently a leaning towards consolidated industrial giants, with less competition.

All things to consider when you think about whether performance going forward will be like historical performance. Did these same anti-competitive conditions exist in 1950 ?

People quote things like 100 year stock market performance. How about in 1920. Was there easy, rapid access to data? Did small investors have access to stocks at low fees? Did indexing giants own huge amounts of the market with the power to influence corporate policies? Did regulators ensure a level playing field between small and large institutions? The answer to all of these is "no"... *the old stock market was radically different*.

My own takeaway: there is no reason to expect stock market performance going forward to be anything like the past. It's simply a different system with a huge number of differences. It might as well be a different country! This aint your grand pappy's stock market and it isn't even your daddy's stock market.


----------



## OptsyEagle (Nov 29, 2009)

I have always thought that they should have a regulatory rule that a fund manager cannot vote the shares that they manage, since they don't technically own them. The same would hold true for ETFs.

I think I remember, not all that long ago, that Blackrock was going to start voting for some kind of sustainability or climate change or whatever. My immediate thought was, how dare they take the investment power of others to direct an outcome of a personal nature. Perhaps if it was outlined in the prospectus, but even then, I am skeptical. I think it can get out of control and put too much power in the hands of too few.

As for indexing. Until it reaches numbers of 50% or more, I think with the amount of non-indexers looking to take advantage where they can, it would be difficult for stocks to get wildly over-valued or under-valued just because they are part of an index. The other participants would steal that advantage away pretty quickly.

Just my opinion of course.


----------

