The ETF Paradox and Defying Physics

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(previously published on LinkedIn)

by Jack Fonss

While ETFs are generally designed for passive indexing, their continued growth means that they may influence and alter the underlying markets they seek to passively track.

ETFs pursue a number of ideals including simplicity, intuitive use, and low cost, but all ETFs are constrained by market realities. Similarly, new ETFs need to promise something novel (and currently unavailable), but where an ETF is constrained by the underlying market that came before it, the measurement of novel and useful becomes subjective. While the “physics” of more and larger ETFs would seem to lead to unavoidable concerns, some clever pivoting in product design may cure these concerns altogether.

New SEC proposed rules are formally raising questions about how ETFs operate within their larger markets in theory and in reality. While further and continued ETF growth might appear to exacerbate market structure concerns, continued ETF growth actually presents opportunities for accurate and less market-impacting ETFs which do not alter or overrun their underlying markets.

Ideals vs. Realities

An ideal ETF should be perfectly linked to its underlying, have unconstrained creation and redemption activities, and be more intuitive to use than its underlying constituents or market. Done to perfection, the ETF becomes a more perfect version of its underlying market than the actual underlyings. As a credit to the ETF industry and many of the industry’s pioneers, a number of ETFs (including many large cap equity ETFs) appear to actually achieve this seemingly impossible goal, and the majority of ETFs do a very good job.

ETFs and Quantum Mechanics

Common wisdom suggests that the physical mass of the ETF space cannot be overcome – that is, as ETFs become larger relative to their underlying markets, the creation/redemption/trading activities of the ETF will influence and alter daily and intraday movements of the underlyings. However, I believe that physics can be overcome with some product design. The measurement linkage an ideal ETF has with its underlying assets has some interesting parallels in pop-science including the Heisenberg Uncertainty Principle, Schrodinger’s Cat, and the Observer Effect.

In brief, Heisenberg states that precision of measurement in one dimension constrains measurement precision in another – “we cannot independently measure the level of the S&P500 and SPY’s price”.

Similarly, Schrodinger suggests that two or more mutually exclusive states can coexist – “volatility ETPs both track and lead VIX futures”

And lastly, the Observer Effect states that the act of measuring a phenomenon (or state) affects the phenomenon (or state) we’re trying to measure – “do commodity ETPs change commodities prices?”.

…collectively the ETF Paradox – ETFs seek to do what may sometimes be physically impossible, and to date they have done it surprisingly well.

Avoiding the Physics – How a Larger and More Complete ETF Market Helps

The ETF industry has continued to deliver more investing tools for different directional views, different time horizons, and a wide ranges of markets and indices. In our current world, each ETF trades independently in its underlying market leaving footprints of order flow, price impact, and transaction costs behind. For a variety of regulatory, administrative, operational, and tax reasons individual ETFs and ETP fund families are largely precluding from netting down (or not trading) underlyings across funds.

With the merging of some new and some old technologies, I believe that ETP fund families will be able to consolidate their share issuance into multi-share arrangements. Consider that many fund families have long (e.g. “+1x”) funds, inverse funds, and leveraged funds in differing direction, where the actual net market delta is low or zero. Similarly, many liquid and widely held ETPs are used as two-way trading tools – reported short interest can be in the billions of dollars. By re-configuring some of the more challenging funds, a largely self-contained ETF ecosystem can be created with less impact on underlying markets. In equities, credit, commodities and other markets, much of the natural demand for longs, inverses and geared funds can be sourced from within the ETF market itself. A well-structured system can deliver the benefits of a self-contained ecosystem and accommodate differing ETF supply and demand conditions.

An industry goal should be an advancing ETF world in which a bigger and more complete ETF marketplace delivers better price discovery and liquidity without the risks of over-running underlying markets.