Von Aldo

Scapegoating ETFs, Part II: ETFs---Weirdly---Still Misunderstood

This morning, I posted a short blog about how the Ewing Marion Kauffman Foundation, a respected foundation that focuses on the promotion of entrepreneurship, released a report criticizing ETFs for hurting capital formation among small caps (dampening IPOs) and, more generally, arguing that ETFs were a threat to economic recovery. They are in good company: None other than John Bogle used to criticize them. Here is an interesting rebuttal against those claims by one of our freelancers, who, by the way, used to work in the research department of the iShares family of ETFs.

Brad Zigler, the aforementioned, long-time freelancer, replied to my query about the Kaufman report thusly:

"Most of the noise raised about ETFs has sounded like axes being ground. Bogle's plaint arose because ETFs looked likely to usurp index mutual funds' hegemony.

Along with all the noise come misconceptions. A lot of folk simply don't understand how ETFs work.

"ETFs have long been recipients of opprobium. Remember Vanguard founder John Bogle likening first-generation ETFs to beautifully crafted shotguns destined to shoot investors' feet?

"I think there's a bit of misconception in the Kauffman report. More particularly, I think the authors put the cart before the horse. ETFs don't supplant investment in small-cap stocks. They actually encourage investment. Small-cap ETF shares are created by the deposit of individual company stocks. Authorized participants have to buy or borrow those shares before the ETF interests can be issued.

"A common 'problem' with small-cap stocks is illiquidity. The inclusion of a small issue into an index that underlies an ETF is bound to increase liquidity for other shareholders. Isn't liquidity a 'good' to be sought out?

"And the opt-out provision? To be excluded from an index-replicating ETF, a company's shares would necessarily have to be removed from the fund's underlying index. What index provider is going to allow an issuer to hijack its intellectual property?

"As far as transparency about creations and redemptions are concerned, opacity is anathema to index ETFs. Some issuers put out better details than others, though. That's a public relations, not a structural, issue.

"All told, I think the criticism of ETFs is misplaced."

ETFs have long been recipients of opprobium. Remember Vanguard founder John Bogle likening first-generation ETFs to beautifully crafted shotguns destined to shoot investors' feet?

Most of the noise raised about ETFs has sounded like axes being ground. Bogle's plaint arose because ETFs looked likely to usurp index mutual funds' hegemony.

Along with all the noise come misconceptions. A lot of folk simply don't understand how ETFs work.

I think there's a bit of misconception in the Kauffman report. More particularly, I think the authors put the cart before the horse. ETFs don't supplant investment in small-cap stocks. They actually encourage investment. Small-cap ETF shares are created by the deposit of individual company stocks. Authorized participants have to buy or borrow those shares before the ETF interests can be issued.

A common "problem" with small-cap stocks is illiquidity. The inclusion of a small issue into an index that underlies an ETF is bound to increase liquidity for other shareholders. Isn't liquidity a "good" to be sought out?

And the opt-out provision? To be excluded from an index-replicating ETF, a company's shares would necessarily have to be removed from the fund's underlying index. What index provider is going to allow an issuer to hijack its intellectual property?

As far as transparency about creations and redemptions are concerned, opacity is anathema to index ETFs. Some issuers put out better details than others, though. That's a public relations, not a structural, issue.

All told, I think the criticism of ETFs is misplaced.

Hide comments

Comments

  • Allowed HTML tags: <em> <strong> <blockquote> <br> <p>

Plain text

  • No HTML tags allowed.
  • Web page addresses and e-mail addresses turn into links automatically.
  • Lines and paragraphs break automatically.
Publish