Exchange-traded funds (ETFs) are all about relationships, so the marriage of ETFs and passive investing looks perfectly fine on the surface. But frighteningly, the basis of their relationship and the reason they look like they pair well will actually be their downfall.
There's the one thing you need to know about ETFs that you probably have no idea about.
I'm going to use a scary word to describe ETFs, although you won't hear the word used when it comes to ETFs anywhere else. That's because not many people understand that the word absolutely applies.
The people who know it's the truth – the sponsors of ETFs, brokers, and regulators – don't want you to ever think of "that" word when you think about ETFs.
ETFs are derivatives.
There, I've said it. Now you know.
What They Don't Want You to Know
An ETF doesn't exist on its own. Every ETF is derived from other financial instruments or multiple instruments, or derivatives of financial instruments.
For example, take the SPDR S&P 500 ETF (AMEX:SPY); the biggest, most liquid, and most traded ETF in the world. The SPY ETF is derived from all 500 stocks that make up the S&P 500 index.
The prices of those 500 stocks are capitalization weighted, and it represents what it would cost an investor to "own the market" if they were to buy one share of each of the 500 stocks in the S&P 500 index.
It's important to understand that SPY (and every other ETF) is a derivative of what securities underlie it.
And that's where the trouble lies.
ETF shares are created from underlying securities when an ETF sponsor (the companies that own ETF families) engages an "authorized participant" (AP) to buy the right amount of underlying securities to accurately represent what the ETF is supposed to track. The AP – who can be a market-maker, a specialist, a broker-dealer, or a big financial institution – buys up the underlying securities and delivers them to the sponsor. The sponsor gives the AP an equal amount of "creation units", AKA ETF shares. The AP then sells those units, or shares, to buyers in the open market. That's how ETF shares come to market.
There isn't a problem with creating more units if demand for the ETF shares is robust. If the stock market is rising and more and more investors want to buy ETF shares to join in the rally, the sponsor will have the AP buy up more underlying shares (which itself can raise prices) and turn them over to the sponsor for creation units to sell in the open market to eager buyers.
But what happens when there are more sellers than buyers? What happens to ETFs then?
What happens can be catastrophic. Especially as more and more so-called passive invest…
About the Author
Shah Gilani is the Event Trading Specialist for Money Map Press. In Zenith Trading Circle Shah reveals the worst companies in the markets - right from his coveted Bankruptcy Almanac - and how readers can trade them over and over again for huge gains. He also writes our most talked-about publication, Wall Street Insights & Indictments, where he reveals how Wall Street's high-stakes game is really played.