ETF Mechanics are Positively NOT Beyond Comprehension - Contrary to Herb Greenberg

Herb Greenberg did a segment on CNBC today about Bogan's "Can ETFs Collapse Piece."  I used to read Greenberg 10 years ago when he was the voice of reason in finding overvalued internet stocks, and found him to be intelligent, informed, and useful.  I guess times have changed.  In this segment, he talks about ETFs like he has absolutely no knowledge of stocks, markets, or mechanics whatsoever and ascribes to them a complexity that would be more aptly associated with particle physics.  If you watch this piece, you'll shake your head in awe that a guy like Herb Greenberg, who should know better, describes hysterically the "complicated" creation units.

Greenberg repeats the hysterical plea of "WHO WILL BE LEFT HOLDING THE BAG?" Which, of course, we already went over in my earlier piece.  Bogan, in the video, even bites my "fractional reserve lending" analogy, but puts a pejorative spin on it.  It happens to be how all stock lending works, not just ETFs.

Greenberg has an article on the subject too, but frankly, when a guy who has been writing about stocks in depth for as long as Greenberg has writes this paragraph, it makes me, simply, sad, and it's an indication that you'll be doing yourself a disservice by reading his article:

"I can’t stress the complexity of the structure. If the very nature of these “creation units” is beyond the comprehension of most investors the actual mechanics of ETFs involve an even far more complex matrix of transactions."

Ok kids - it's time to dump Herb Greenberg as your source for lessons on market mechanics.  Instead, come to Kid Dynamite's World, because, you see, these "Creation units" are such a simple concept that I could explain it to your grandmother in 5 minutes.  In fact, of course, I already did.  Here's what I wrote:

"One of the great things about ETFs is that they can be created and redeemed.   This means that "authorized participants" (read: big broker dealers) can take a basket containing the underlying stocks of the ETF, in specific weights, deliver them to the ETF trust and receive the ETF shares - that's called creating.  They can also do the opposite:  deliver the ETF itself to the trust, and receive the underlying basket of individual stocks - that's called redeeming.  "

(SARCASM ON)  Holy cow - that is incredibly complex - and nearly impossible for all but the most elite among us to understand. (/SARCASM OFF)  

You take a basket of stocks and give it to the Trust - they give you the ETF.  Or, you take the ETF and give it to the trust - they give you the basket of stocks.  WTF is complex about that?

A key realization is that the larger the short interest in an ETF is, the higher the probability that you get a short squeeze if and when people want to redeem their shares.  This short squeeze kicks off a "self healing" process that I described in the previous post, resulting in arbitrageurs creating the shares that are needed, and avoiding the feared collapse.

 

Amazingly, neither Bogan nor Greenberg realize that an ETF is probably more likely to "collapse" - in the sense that everyone wants to redeem and can redeem because they haven't lent their stock out -  when there is NOT massive short interest.  Imagine the simplest case where there is ZERO short interest - no shares are lent, and long holders can simply redeem their shares. (In order to redeem, you have to actually deliver your shares to the Trust, which you can't do if they are lent out, until, of course, you get them back). In the massive short interest case (Bogan's XRT example), shares have been lent (to short sellers), and thus cannot be redeemed until they are recalled from the short seller (again, I explained all of this in the other piece already) - and that borrow recall process results in short squeezes and creation of new shares, which self-heals the problem of "missing" shares (which, of course, aren't really missing at all - because only the shares that are actually outstanding can be redeemed.)

Just to help you guys sleep at night, after Greenberg rants aloud "Who will be left holding the bag? Will it be the Federal Reserve?"   No - it will not be the Federal Reserve. I answered this question already also.  In the event that an ETF gets "redeemed" out of existence (which, again, Herb and Andrew, is MORE likely to happen if there is LESS short interest),  shorts owe longs the value of the underlying basket.  Cricket.....  Cricket.  The sky doesn't fall,  the oceans don't boil, locusts don't swarm, and the Fed doesn't have to pick up the tab - it's just an exchange of cash from the shorts to the longs (and it's already collateralized when the short seller shorts the stock and posts margin).

It would be somewhat understandable for a mass media business section author to write a piece like the one Greenberg did today, but Herb - you have no excuse - you should know better.

-KD

author's note:  If you haven't read my first piece on this subject, you should do so.

also, a question for my readers:  In the first few seconds of the video clip, Faber mentions "the gold ETF" failing to track the price of gold.  Does anyone know what he's talking about?  Surely not GLD, which has tracked the price of gold tightly. (And this is not an invitation for people to leave "GLD IS A SCAM" comments - I just have no clue what Faber was talking about)