Until today, I believed a plain vanilla ETF (not an ETN) was an excellent and SECURE way to track the performance of a stock index. Today, I was horrified when I read this article http://ftalphaville.ft.com/blog/2010/09/18/346406/can-an-etf-collapse/ From my understanding of this article, they are talking about a plain vanilla stock etf tracking the performance of a stock index, i.e., from my understanding, the ETF is supposed to hold the underlying stocks = physical stocks of the companies that make up the index (i.e. this etf is NOT a complex or exotic product based on swaps or other derivatives). I thought holding such a vanilla ETF was equivalent to owning the physical stocks of the companies making up the index. However they explain in this article, you can buy shares of an ETF where the underlying stocks DO NOT EXIST as you might buy them from a short sellers who makes a promise to create more shares at a later date when they cover their short positions. I am not sure to understand properly, but it seems that when you buy the ETF from a short seller, you are buying something virtual and that means you buy nothing??? Therefore if there are lots of ETFs short sellers, the price of the ETF can deviate enormously from the price of the index and in the worst case scenario, the value of the ETF would go to zero. If the price of the ETF was enormously decorrelated to the price index, or if the ETF collapse or cease to exist for any reason, I would have thought that I would have been able to sell the company stocks in the market. But since I've bought a share of the ETF from a short seller, I don't own the stocks and I don't own anything really!!! Is it total bankruptcy??? I also read an article about what is called "ETF death watchlist", I am not too sure what this is about. It seems this is a list of ETFs that are likely to close and I read investors are advised to get rid of these etfs on death watch list as the etf could close. I am not sure in the etf death watch list is related to the etf collapse article. I am new and trying to learn about ETFS, and very confused. Can someone clarify if etfs are secure instruments, are they regulated by the FSA in the UK or the SEC in the US? When you buy a share of an ETF, is that really possible that you don't own the underlying stocks of the companies if you buy the ETF from a short seller? This article might be rubbish but I've found others similar articles when typing "ETF collapse" in google, so I am in doubt and very very confused! I hope someone with some expert knowledge can clarify the matter.
That article is a "scare tactic" to keep people away from ETF's. Those guys probably got paid by some mutual fund, who knows. Can an ETF close down? Of course, but they'll likely return the fund's NAV to you upon liquidation. Is it better/safer to own the stocks? Probably. ETF's are listed on all major exchanges from NYSE, Tokyo, Paris, Frankfurt, London, etc. They and their sponsors are regulated. It really depends on what your objectives are with any ETF. The same could be said of just about any other financial instrument. However, if you're still not sure/afraid, then buy a mutual fund with the same composition as an etf and you'll probably achieve the same results. Not sure about management fees though. In the end, they're very comparable. Mutual funds are more for the long term bag holder. Short interest/Open interest in ETF's don't really mean much.
Sure ETFs can collapse. For example, SPY could totally collapse if all of its underlying securities went to zero. ETFs and Mutual Funds are the same thing. The vast majority of ETFs are 40-Act Funds, so consider them a Mutual Fund with intra-day liquidity vs. a Mutual Fund pricing only once a day. Management fees will typiclly be lower in an ETF since you pay your broker the ticket fee to buy/sell where Mutual Fund Management Fees are going to vary depending on whether or not they are NTF/NRF and if they have a lockup/holding period.
You can go to proshares.com or spdrs.com and read the prospectus on all their ETFs. Some ETFs actually far out perform the index they follow, like SPY for example, because the index doesn't account for dividends, but in real life, the companies do give dividends. So, if you hold SPY, you'll track the gains of the SandP 500, and you'll also get a dividend, so over time you'll far out perform. Short of some historic dramatic event, I don't think there's any worry with the spdrs ETFs or proshares ETFs. Just read the details to see how each ETF works. Stay away from the double or triple ETFs.
Same thing can happen when you buy stock. I think OSTK a few years ago had many more shares short than the entire float. Are ETF's more susceptible to this problem than ordinary stocks?
to answer the fundamental question from the OP, let's say there's a company with 100 total shares in the market. This company pays $100 in dividends a year, $1 to each share. Suzy short thinks the company will lose value so she borrows 10 shares from another holder and sells them to a new shareholder. Now, there are 110 long sharess, and 10 short shares. So when dividends get paid, the corporation pays $100, while suzy pays $10 to the person she has traded against. So yes, there are 10 "fake" shares. As far as bankruptcy, etc- this is a non-concern. The brokerage that holds the short position monitors Suzy's account to make sure that she's able to cover the loss, and then some, at all times. If there's any question, they will force her to buy to close. If it's too late and Suzy has lost more than she can afford, the brokerage is on the hook. The brokerage must cover all the losses, and will probably buy to close the position immediately. If this causes too many losses for the brokerage that they go bankrupt, the SIPC steps in, covers losses, and helps clients recover their investments. Fun stuff, huh.
Keep in mind that the job of the ETFs managers is to monitor stocks and exclude weak stocks from the index listing. On the other hand it took more than half of year for S&P to remove City stock from the S&P 500 listing after its crash in 2008. Still the beauty of ETFs is that you do not have to focus on fundamental analysis.
Isn't this an example of a "naked short" where the person is short without having secured shares to borrow? If so, isn't that illegal? (Yes, yes, I know that the SEC is a useless joke...)