ETFs: A Broken Business Model

ETF closures a telltale sign the business model is broken

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The industry has created a model that relies on the creation/redemption mechanism to function. Without the ETF sponsor and authorized participant (market maker, institution, etc.), there is no ETF. The behind-the-scenes machinations of the primary ETF market keeps the share price in line with the value of the underlying securities. Because the authorized participant assumes all of the trading costs and fees, the management expense is kept low, unlike mutual funds, where trading costs are assumed by the fund itself.

In theory, it’s a wonderful concept.

However, it’s a model that keeps the power squarely in the hands of market makers and institutional investors because to play the game, you’ve got to own the underlying securities of a particular fund in large enough quantity to exchange for creation units, typically 50,000 share chunks, which then are resold to the public at a profit.

Market makers and institutions aren’t doing this out of the goodness of their own hearts, but rather for cold, hard cash. We are the pawns in their game.

There are five major players in the U.S. index business: Standard & Poor’s, Russell, MSCI, Dow Jones and Morningstar. From these five companies, hundreds of ETFs have been created based on various indices. Why can’t you take $1,000 down to your local Schwab office and have them invest it in the stocks that make up the S&P 500 with the same exact weightings as the index?

In a world where I can watch TV on my phone, how is it that individual investors are unable to buy fractional shares of company stock?

Washington-based FolioInvesting allows you to buy fractional shares, but it doesn’t give you the option to own the entire S&P 500. Instead, it has the Folio 50, which is the 50 largest stocks by market cap in the S&P 500. It’s close, but no cigar. However, the simple fact that it can do this suggests that the technology exists to make it happen.

And that’s the crux of the matter. Individual investors have little say in how they purchase their investments. Years ago, when online trading brought the cost of investing down, everyone thought individuals gained the upper hand. Not so much. We still have to go through a middleman to own the index.

I used to think many of the indices being created in recent years were simply a marketing tool for the inevitable ETF. But now that I see all sorts of funds closing, I realize that there’s nothing intrinsically wrong with the creation of indices like the Solactive Global Fishing Index, which until recently was the tracking index for the Global X Fishing Industry ETF. Although the ETF was shut in February, the index itself lives on. I should be able to buy the stocks in that index at my desired level of investment using current weightings, avoiding the ETF machine all together.

Alas, I can’t.

The democratization of investing, as witnessed through the ETF oligopoly, is a long way off. Only when we can do what I’ve described above will we be truly free.

As of this writing, Will Ashworth did not hold a position in any of the aforementioned securities.


Article printed from InvestorPlace Media, http://investorplace.com/2012/09/etfs-a-broken-business-model-blk-stt-vanguard/.

©2014 InvestorPlace Media, LLC

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