A unit of Thomson Reuters broke word that the big bank will helm a team of other big banks for what in May could be the biggest IPO, raising perhaps $10 billion.

We don’t care who underwrites the deal. But thinking about Facebook and its banking soldiers of fortune, the giant and the mighty in massive conformity, we thought of the markets.

In the data we track, Morgan Stanley is king of index program-trading executions. For large clients of ours, its volumes surpass those of small exchanges. At the Nasdaq, Morgan Stanley is the top liquidity provider, trumping fraternal behemoths BofA Merrill and Barclays and high-frequency clearing maestro Wedbush. Last June, Global Custodian’s annual ranking of prime brokers – banks bundling securities services for the buyside – slotted Morgan Stanley a close second to Goldman Sachs.

We wrote in September how the same names show up everywhere. The ones running books of derivatives, making markets in Treasuries, trading bonds electronically and correlating seas of equity executions are the same.

Lost in the long shadows of the large was word that technology research boutique Kaufman Brothers closed its doors this week. Ticonderoga Securities shut down earlier is month. Formerly Reynders Gray & Co. on the floor of the NYSE, the firm offered differentiated research, direct-access trading and agency executions. WJB Capital, another boutique, shuttered around January 4 after failing to raise capital and seeing its financing costs rise as high as 25%.

Even mid-tiers are hitting headwinds. Memphis-based Morgan Keegan & Co owned by Regions Financial Bank will be acquired by Florida’s Raymond James.

Morgan Stanley and its monolithic kin by right win monumental deals. No argument. But it’s not underwriting we’re thinking about. It’s the way stocks trade. We know when dark-pool volume jumps at Morgan Stanley, or if behavior there departs from other program behaviors. But with ever fewer small brokers offering unique trade executions, markets lose vibrancy.

Many small brokers can’t meet trade-execution rules, so must route orders to big firms. Others receive payments for order flow, which mammoth brokers consolidate. Think of an elevator. People of different shapes, sizes, speeds and energy board it. Then all travel at the same speed – that of the elevator.

That’s what happens in markets. If investors want to buy your shares through a small broker providing research, and those orders route to Morgan Stanley for execution, they’re likely internalized or amalgamated into algorithmic schemes serving unintended ends. Thus, your price reflects program-trading rather than rational investment.

We’re glad Facebook and Morgan Stanley are around. But there’s irony that in a social world, markets are sterile machines. It’s curiously antisocial.

If at first you don’t succeed, try, try again. So it goes at the Nasdaq.

Last autumn the exchange proposed to charge small-cap companies fees of up to $100,000 to incentivize market-makers to trade small-cap ETFs, arguing to the SEC that it would infuse thinly traded securities with liquidity. The rule would have required the SEC, FINRA and the exchange itself to reverse longstanding prohibitions on paying market makers to trade securities. For certain exceptions only (of course, exchanges pay billions of dollars in rebates to “liquidity providers” each year).

The SEC promptly rejected the rule-filing. Now it’s back. See it here.

IR folks, do you know the adage about being wise as serpents but meek as doves? Question what you hear from exchanges that rely on data and transactions – not issuers – for revenue and profits. Take nothing at face value. Examine the facts.

First, why liquidity? Berkshire Hathaway Class A shares need no liquidity to achieve a low beta and high institutional retention. So is trading activity in liquid names investment – or something else, such as statistical arbitrage?

Second, understand how ETFs work. To meet fluctuating supply and demand, ETF sponsors create and redeem units daily through authorized participants (APs) consisting of broker-dealers and large institutional investors like Vanguard and Fidelity.

Setting aside that unfair advantage (and stat arb opportunity) for APs, can you create and redeem your shares daily? No. What does incentivizing trading in small-cap ETFs create, then? Arbitrage. Statistical calculations of fluctuation in a set of securities. That’s not investment, it’s noise. Worst, the Nasdaq wants you small-caps to pay for it in your stocks – so it can generate more data and transactional revenue.

Lesson: Exceptions to rules always foster arbitrage. Apply it to any scenario, from taxes, to trading, to regulations.

So express yourselves. If or when this proposal reaches the SEC, go here, find the rule filing, and comment. One public company can change outcomes.

Here’s proof. The letter from ModernIR is referenced in the SEC’s decision to extend discussions about extraordinary market volatility. We were just one voice (none from public companies!) – but every voice counts.

We’ve opined again on market-volatility rules. Please read it. In two pages, we summarize how market rules are depriving public companies of what they want most in trading markets: Differentiation.

Your company should comment, too. So be heard, be seen, and be counted.

One of our technology geeks shared a link at TED, the place where nerds of a commonly self-aggrandized feather gather to bloviate about culture. In this one, Kevin Slavin, founder of a game-hatching thought shop bought by Zynga, discusses how algorithms run our world. The guy is a good speaker and knows his imagery. Of algorithms, he says: “We’re writing things that we can no longer read.”

Slavin sets up his piquant point this way. He was on a flight with a Hungarian physicist who’s on Wall Street writing algorithms. The Hungarian used to work for the Soviets using math and physics to find American Stealth aircraft. Apparently, technology dissolves the signature of Stealth planes into a million fragments so they won’t look like planes to radar. The Hungarian wrote equations to find electronic tidbits hiding planes.

Lo and behold, Wall Street is doing the same thing. Institutions are using algorithms to break down their stealth moves to buy and sell shares into a million pieces so they don’t show up on anyone’s screen. They’re hiding the aircraft, disguising the elephant. And a whole bunch of other algorithms are out winnowing signals to assemble patterns that show where elephants are pirouetting across putting greens.

I thought professionals in the IR chair could use this imagery. It’s not new to us. But it’s a way to explain trading to execs. Slavin notes how this activity comprises the great majority of volume, one part hiding what it does, the other trying to discover it. As he says, “This is your pension, your 401k, your mortgage.” And: “We’ve lost the sense of what’s actually happening in this world we’ve made.”

Something else struck me. Slavin relates a vignette from an auction at Amazon for a book out of print. The price goes from $1.7m to $23.7m. Nobody was buying or selling the book. No human said, “You know, $1.7m is enough really.” Machines were in combat, applying what Netflix calls pragmatic chaos. Choreographed machine rationale without common sense can imagine demand or recommend movies for you.

It can also assign prices to stocks. Algorithms assemble and fragment things. The things have no inherent value. Prices are zeroes and ones blended and dissolved at speeds many times faster than the click of a mouse. Numbers, grids, patterns, probing. It’s hide-and-seek. It’s Stealth warfare.

And here come earnings again. Everybody will look at the market for a sense of what investors think. We can’t even read what we wrote. Pragmatic chaos.

Regulators are trying to make a big Off Button to press on the inevitable day when pragmatic chaos picks incorrectly. Maybe we should just unplug it.

It was a rock tied with a leather strand to a wooden stand. The instructions said: “If rock is wet, it’s raining. If rock is dry and hot, it’s sunny. If rock is cold and covered with fluffy white layer, it’s snowing.”

Similarly, I saw this in a recent Bloomberg article: “The best way to keep pace with the S&P last year would have been a strategy that rotated between sectors based on the macro headlines,” said David Spika, fund manager at Westwood Holdings in Dallas.

That sounds a lot like “if rock is wet, it’s raining.” The elegance of simplicity notwithstanding, how do you distinguish the IR chair and your company’s shares in a market moving on whether the rock is wet or not?

One argument says you change your focus. Deemphasize the capital markets and instead get baptized in Dodd-Frank, proxy evolution, say-on-pay and myriad others rules and regulations oozing like molasses through public capital markets. Become a compliance concierge. Well and good. But you’ll be competing with internal and external legal counsel for thought leadership, and I find that the advantage lawyers have is they have law degrees.

Or you could change the world. Sure, that sounds hard and complying seems easy. But come on, who wants to just mark time on the IR hamster wheel?

Try this bold strategy. Ask your CFO to add three things to your job description: A responsibility to become the internal expert on trading markets. Point person for monitoring your exchange and the SEC for rules affecting how your stock trades. And “Chief Economist” for your company’s currency – your traded shares.

Which one sounds like more fun? Complying or changing the world?

You can’t change the world in eleven seconds. Only Tim Tebow can do that. But you can spend time each week educating yourself on how trading markets work. You can read rules your listing exchange proposes and advise management on whether to comment on ones harmful to your investors’ interests. One reason why markets are great for 5-second investment and lousy for 5-year investment is that those making the rules love 5-second investment.

And if you do those, and add in knowledge of macro factors, you’ll be an effective Chief Economist. A step at a time, instead of an 80-yard pass play to the end zone, you can help restore sanity and vitality to our profession. That’s good news, rewarding, and fun to boot.

And, go Broncos!

And with good reason. The lovely KQ and I winged southward with fellow wayfarers for time over the keel on the cayes and reefs of Belize. At Queens Cayes east off Placencia past the wildlife preserve at Laughing Bird Caye, we found what one friend called “your own Corona commercial.” As the sun faded toward dusk there, we caught this grand view of our boats on Dec 11. Our companions below the surface included this delightful fellow, a spotted eagle ray. The Eagle Ray Club is a good name for a rock band.

Inland on the far side of our trip we trekked the jungle and climbed this spectacular Mayan temple at Lamanai in the Orange Walk district. Lamanai, with some 32,000 structures hidden by the jungle, once was home to 60,000 Mayans. If the world ends next December (this comic strip offers an alternative view), we’ve redeemed the time between the best we could.

Speaking of speaking, the SEC in latter December told the Nasdaq no-way on its Market Quality Program proposal that would have authorized the exchange to charge small-cap stocks an additional $50,000-$100,000 annually to incentivize broker dealers to make markets. Read the proposal here (we say “read” loosely, as it’s composed in “marketstructureeze,” intelligible if you have a decryption tool akin to what the Allies in World War II used to debunk the German cipher machines called Enigmas).

The Nasdaq, NYSE, BATS and Direct Edge (as well as other exchange operators) file many rule-making proposals each year. These rules affect how your stock trades and often incentivize the very things making markets loathsome to real investors: statistical arbitrage and high-frequency trading. Why? These behaviors are essential to exchange profits. Thus, in 2011 alone, the Nasdaq, curator of the most codicil constipation, filed at least 171 rule proposals. The NYSE made 73 proposals, and BATS and Direct Edge 51 and 42, respectively.

SEC regulations require comment periods for each proposal. We weigh in when a rule strikes us as unhelpful to public companies. We cannot recall ever reading a single comment letter from a public company on any rule filing. Why? Good question. Public companies should be a key voice in the markets where their shares trade. Instead, listed companies have seemingly handed the hen house to the coyotes.

How about a New Year’s Resolution, IR pros? Resolve this year (this week?) to involve your General Counsel in watching the rule filings from your listing exchange.

Heck, do it yourself. Fast-trading is a by-product of exchange trading incentives. Nobody drives these more than statistical arbitragers and high-frequency traders from both sellside and buyside. As in any loyalty program, exchanges give their best customers the most attractive trading rates. But their best customers are often your worst enemies – in terms of setting real, natural prices.

It continues because thou protesteth too little. Read and comment on rule proposals from the NYSE, Nasdaq and BATS at the links below. You can view other comment letters to see the best way to opine, but it’s straightforward. Write a letter explaining your objection, emphasizing your standing as a publicly traded company listed by the exchange:

http://www.sec.gov/rules/sro/nasdaq.shtml

http://www.sec.gov/rules/sro/nyse.shtml

Exchanges’ sites:

http://www.nyse.com/nysenotices/nyse/rule-filings/list?year=2011

http://nasdaq.cchwallstreet.com/filings/

Let’s make 2012 The Year That Public Companies Spoke Up.

Oscar Wilde said that illusion is the first of all pleasures. Of course he also wrote that anyone who lives within his means suffers from a lack of imagination.

Buttressed on either side with those brackets about illusion and means, let’s look today at what’s afflicting our market and why some institutions like transient trading when others don’t.

Vanguard, an institutional investor focused on passively managed funds, supports high-frequency trading. George Sauter, CIO for the Vanguard Group, wrote in the firm’s comment letter to the SEC on market structure that high-frequency volumes reduce trading costs through competition and tighter spreads. He quantifies the benefit to investors at roughly 10% over a decade. A passive fund providing 9% returns per annum would deliver only 8% returns without HFT.

By contrast, Mason Hawkins, founder of Southeastern Asset Management, which runs active investments for subsidiary Longleaf Partners, commented to the SEC on April 28 that intermediation by short-term traders costs long-term investors $20 billion per year, distorts true prices, crowds growth and value capital out, and delivers no social purpose or benefit, like investment capital.

How can two marquee institutions arrive at such dissonant conclusions? Different purposes and time horizons – a crucial element of understanding market structure. These are our views now, not Vanguard’s or Southeastern’s. Vanguard rebalances assets constantly as redemptions and inflows wax and wane, benchmark indices reconstitute – as occurred both June 18 and June 25 – and assets are allocated. Regardless of purpose, these monies follow risk-management tenets, and algorithms work like a blender, combining many different ingredients into a smooth batter.

The maker-taker model of markets today, where the consumption and production of liquidity describes market function and architecture, is ideally suited to Vanguard. It works well for general, standard-deviation, risk-management. We could go on at great length here. You’ll be glad to know that we won’t.

Southeastern Management, on the other hand, is seeking intrinsic investment value. This time horizon and purpose faces execution disadvantages now because the aim of the money is fairly singular. Constant high-speed re-pricing of securities doesn’t meet its needs.

We’re talking strictly about market function, not what theses prosper. But think about it from an IR perspective. Which investor is going to entertain your management team? So which sort of execution should concern you?

Which leads to our concluding point, for which we owe thanks to alert reader Leen Simonet at Coherent, Inc. On June 18, 2010, S&P indices rebalanced for the quarter. On June 25, Russell indexes reset for the year. Leen noted that these events lent themselves to strange market-structure conditions. We saw it in the data – massive leverage. We could only conclude that money made bets on divergences between components and on the supply and demand of shares that might arise as a result. We think swaps – market positions in off- market contracts, not open-market transactions – were huge. We saw tremendous cash trading at options desks.

These are speculative tactics, not investment purposes. They resulted in significant losses of market capitalization for issuers. On the whole, markets – we had warned that this might well occur with expirations – experienced a big shift in dollars from equities to derivatives.

The money behind it isn’t concerned with prudence, such as living within one’s means. It’s all about the gaps. Maybe Oscar Wilde would approve. But he would probably say it lacks imagination.

I don’t mean gambling, but real cards. You’re engaged with some seriousness. You’re watching how you bet and when, reading the players ahead and after you.

Then The House starts doling out stacks of chips. Would you play more or less cautiously if you had free chips?

Apply this thinking to equity markets, IR folks. In trading data, we saw European money sweeping into US equities Nov 28. Why did markets trembling Nov 25 decide by the following Monday to up the ante in risk-taking? Primary dealers implementing policy for global central banks also drive most program-trading strategies.

Thus, European money surmised that central banks would intervene, and their behavior reflected it. The rest caught on, and markets soared Nov 30 on free chips from central banks. It was short-lived. By Dec 2, we saw institutions market-wide assaying portfolio risk and locking in higher derivatives insurance. The chips were gone.

Money sat back expectantly. On Dec 8, The House delivered chips as the European Central Bank lowered interest rates. That’s devaluing the euro. At first, cheapening the euro increases the value of the dollar – which lowers US stocks (a la Dec 8). But if you’d hedged with derivatives as most of the globe did, you bluffed The House. Plus, the Fed will likely have to follow Europe’s bet up with a see-and-raise to devalue the dollar back into line with the euro (expect it next week, but before options expirations).

In poker, having “the nuts” is holding the best cards, and knowing it. Central banks have given arbitragers the nuts.

Arbitrage is a buy-low/sell-high strategy that depends on gaps. Say you’re in rush-hour traffic and all the cars are packed together and then a little gap forms and somebody shifts over from another lane. That driver has just arbitraged lanes of traffic. Now suppose suddenly a new empty lane materialized?

That lane is a stack of free chips in poker, or monetary intervention. A windfall. Global statistical arbitrage is money in planetary slosh after gaps. Remember, money can trade your equity, your options and Treasury futures in one fell swoop, in seconds or less. Or any random collection of electronically tradable securities from here to Stockholm.

Gritty rational money has bought growth issues, too. If inflation in equities is likely because The House may wander through with more free chips, that’s “growth,” not value (but is inflation growth? Hm.).

Generally, arbitrage makes life difficult for thoughtful investors. Investment certainty requires a fair and simple game. You buy in, you play your best, you win or lose. No free chips from The House.

So expect arbitrage. Expect volatility.

After breaking for a week as an act of giving thanks, we’re back. Karen and I joined 88,622 others in Aggieland at Kyle Field in College Station for the A&M football game last Thursday versus the Texas Longhorns. Disappointing outcome, great Thanksgiving.

There’s something special about Texas. People passing you on the street say hi and the kids say yes ma’am and yes sir. There’s a lot of what Kenny Chesney calls “the good stuff.” What may be the world’s greatest college bar, the Dixie Chicken, sits on the main College Station drag like an Old West saloon. Batwing doors, even.

Speaking of swinging doors, gyrations in markets make it awfully hard to use your stock price to measure investor sentiment (wasn’t that the idea behind exchanges?). In fact, there’s inherent contradiction between the way markets behave now and how the IR profession cultivates holders.

IR folks typically seek buy-and-hold money that does not trade. Yet executives frequently ask about the stock price. The news rushing at us round the clock tries to explain market behavior in rational terms. Yet stock prices are set by the latest fleeting bid or offer. Nine of ten times, those prices are not rational.

We advise clients to track Rational Price – our measure for the level at which thoughtful investment behavior jostles through the batwing doors of the market to compete with the din in there and stamp a price on your stock. It doesn’t happen often, frankly. About half the client base has had no new Rational Price since about Nov 4. The time between has mostly been about fear and greed vacillating around the euro.

One lesson: If you want rational money setting price, target investors with shorter horizons who’ll shoulder the batwing doors more frequently. If you’d like to hear more about rationally quantifying market behavior, send me an email and ask for our white paper on Measuring IR in Modern Markets.

Speaking of markets, we’ll wrap with a word on them. We warned clients that investors were shifting from equities to derivatives with options expirations Nov 16-18. We saw the biggest use of VIX S&P 500 volatility futures since August. The cause? The euro.

You remember a year ago we were talking about the potential demise of the euro? In a Wall Street Journal article Monday, ICAP Corporates, the biggest “wholesale counterparty” broker helping investors swap this for that globally, said it’s running tests for the return of the Greek drachma and maybe other national currencies.

The implication for IR? Trading is global. We track its impact on clients large and small. A euro-zone fracture would bring into question valuation mechanisms for entire global markets. Right now, it’s all relative. In 1999-2000, the euro’s creation coincided with a significant devaluation of the dollar and a huge bubble in stocks.

 In a bombshell dropped at a congressional hearing yesterday, top executives for the NYSE and the Nasdaq proposed – to borrow from humorist Dave Barry, we SWEAR we are not making this up – that you pay them fees, small-cap companies, which they will distribute to market-makers to incentivize trading in ETFs that trade your shares.

 Exchanges already incentivize most trades, but in the hundred most liquid names there’s great profit in the data off the consolidated tape. You small-caps offer no profit. So in addition to charging you listing fees, they now want to charge you market-making fees – but in the ETFs that hold your stocks.

 Congresspersons unfamiliar with how arbitrage works and how ETFs are principally one-day investment vehicles won’t see through this self-serving and patently ridiculous proposal. The SEC may also overlook the glaring contradiction to well-functioning capital markets and approve it. Public companies don’t read exchange proposals as they should and don’t comment on them.  No opposition? Approved.

 For more, we’ve asked permission to re-run a blog post today by Joe Saluzzi at Themis Trading:

Yesterday, representatives from the NYSE and NASDAQ essentially admitted that the current fragmented market structure has been a failure for most US companies.  Before a House Committee on Oversight and Government Reform, Eric Noll from Nasdaq had this to say:

 “The unintended consequences of the market fragmentation has been a lack of liquidity and price discovery in listed securities outside of the top 100 traded names and a disturbing absence of market attention paid to small growth companies by all market participants including exchanges.”

 Joe Mecane from the NYSE added that even though spread compression has happened in the most liquid, largest stocks where HFT is present, the unfortunate reality is that those same trends have not occurred in the small to mid-cap part of the market.  He said these stocks do not have sufficient liquidity for the HFT traders to traffic in and as a result you do not see the volume and spread compression that you do in the largest stocks.

 The solution that these two exchanges have come up with is to have the corporate issuers pay a fee to market makers in the small to mid-cap sector to encourage them to add liquidity to the market.  But they had a little problem.  FINRA banned this practice in 1997 because they feared public companies may be paying to have their stock prices pumped up.  So, the exchanges came up with a creative idea.  They proposed having the corporate issuers pay a fee to market makers who make markets in ETF’s that the corporate issuer is a component of.  Here is how Mr. Mecane spun it according to a Bloomberg Article written by Nina Mehta:

 “There is a conflict inherent in a situation where a company itself is paying a liquidity provider to make a market in a stock,” Mecane said. Since the prices of ETFs “are generally linked back to the underlying securities, there’s less opportunity for manipulation”.

 Less of an opportunity for manipulation?  They have to be kidding.  When we first read this, we couldn’t believe it was true.  We could not believe that exchange executives would be trying such a financial gimmick.  So we viewed the hour and half congressional hearing (View hearing here) and confirmed everything in the Bloomberg article (skip to the 33 minute mark to hear the proposal).

 Let’s think about what these guys are proposing.  They want ETF market makers to receive a payment for adding “liquidity” to an ETF that has small to mid-cap components.  Their circular logic implies that if the ETF is trading then the stock components must trade more. 

 Well, it looks like they forgot about the magic of creation and redemption of ETF’s.  This magic, which has actually suspended the laws of supply and demand for stocks, allows authorized participants to not even have to trade the underlying stocks.  They just get issued more ETF units or redeem ETF units at the end of the day.  

 According to shares, “Unless a company decides to issue more shares, the supply of shares of an individual stock trading in the marketplace is finite. When demand increases for shares of an ETF, however, Authorized Participants (APs) have the ability to create additional shares on demand.”  Take a look at this iShares video  for more information on the magical process of creation and redemption.

 Why would a corporate issuer want to pay an ETF market maker a fee?  Don’t they already pay the exchanges a listing fee each year.  What value are they getting for that listing fee?  The corporate IR folks that we have spoken to lately seem to think there is little to no value for this fee.  Many have said they do not have any information about what goes on in their stock and actually preferred the old specialist model.  Maybe the exchange should just pass this listing fee over to the ETF market makers if they are so concerned about the small and mid-cap stocks.

 But the real issue that has been exposed here is that the current one size fits all, hyper speed, short term stock market model which was born out of the 1990’s SOES bandits has been a failure and has hurt the capital formation process.  The stock exchanges have failed the American public and have now finally admitted it. 

But how do they propose to fix it…with more parlor games and financial shenanigans.  When will they finally realize that the only way to create liquidity in small and mid-cap stocks is to stimulate INVESTOR interest.  This is done by bringing back the economic incentives for brokers to once again properly research, support and distribute their analysis to the investment community so that institutional investors can INVEST in small companies.   

 For years, the for-profit exchanges have tried to protect their own financial interests by promoting the current fragmented model as efficient for all companies.  We are glad that they finally admitted that it’s not working but we are saddened that they are still putting their own financial interests ahead of the investment community.

Because ETFs are miraculous.

The biblical story of creation is that something came from nothing. Same with the Christian concept of redemption – being bought for a price without rendering equal worth in kind.

Today, we’ll share with occupants of the IR chair the divine story of how ETFs work.

Before ETFs were closed-end mutual funds. Closed end funds (CEFs) are publicly traded securities that IPO to raise capital and pursue a business objective (like any business), in this case an investment thesis. Traded units have a price, and the net asset value rises and falls on the success of managers in achieving objectives. The rub with CEFs is that share value can depart from net asset value – just like stocks often separate from intrinsic business worth.

The investment industry, with support from regulators, devised ETFs to magically remedy through Creation and Redemption this fault of nature. ETF kingpin iShares, owned by Blackrock, illustrates here, with a clever floral analogy (thank you Joe Saluzzi at Themis Trading who alerted us to it). You don’t have to buy individual flowers and face market risks because iShares puts them in a bouquet for you. Great idea.

Now suppose instead of one bouquet you want a thousand? In the market, what happens if someone suddenly wants not a hundred but ten million shares of your stock? Supposing such a trade were even possible today, the impact on your market would be extraordinary. But what if you could instantly issue ten million shares – poof, out of thin air? Your stock price would stay the same, because supply would swell to absorb demand.

That’s what ETFs do. They create shares. They must specify the methodology in their prospectuses. For instance, the iShares Telecom ETF “IYZ” says “Creation Units” are blocks of 50,000 ETF shares that it will issue to certain “authorized participants.” Some are brokers, some institutional investors. In turn, these participants supply the ETF sponsor with the designated set of assets – the mix representing the ETF’s constitution. In the case of IYZ, it approximates the Dow Jones US Telecom Index.

Redemption is the reverse. The ETF sponsor “redeems” shares by taking back units and returning constituent shares. The elemental concepts of supply and demand are neutralized. Prices of components miraculously stay the same even as tens of billions of dollars flow to ETFs. It’s almost…perverse.

The ETF sponsor as God and creator of the ETF charges authorized participants a licensing fee and buyers of ETF shares a management fee. This seems a good business – charging fees both directions while you work your ETFs like bellows.

But there’s more. ETFs can only be created and redeemed in blocks – 50,000 shares in the instance we cited above. Beyond the obvious inclination for brokers and institutions to “manufacture” units of ETFs from discretionary liquidity as a way to offset portfolio risk without paying for it, the arbitrage opportunities around assembling and disassembling Creation Units stagger the imagination.

You can short ETFs. You can buy, sell and short options and futures on the underlying indexes. Buy, sell and short the components of indexes, and of ETFs, and the options on components. You can buy, sell and short ETF options. You could buy, sell and short closely related ETFs and all their components and related derivatives. You can swap them all, spread-trade them, buy, sell and short the volatility among them.

And how about trading ETFs long or short in small increments and then creating or redeeming units inversely in large chunks if you’re an authorized participant? Institutions and brokers are doing this with highly sophisticated algorithms. Software providers like Tethys Technology abound for maximizing outcomes.

The key to this kingdom, this arbitrage nirvana, is that one entity, through creation and redemption, is stable, while all the others vary.

No wonder ETFs are responsible for some 35-40% of daily market volume. No wonder everything is massively correlated. If ETFs drive demand for components, and ETF units expand and contract to stabilize prices, then price movements of individual securities become volatile intraday, yet major measures come rapidly back into correlation.

The problem is apparent: If the medium of exchange adjusts to fit supply and demand, how do you buy value, or growth? Prices revert to the mean, irrespective of value or growth prospects.

Yet value and growth are the pillars of capital-formation.

What’s more, ETFs are one-day life cycles for industries, sectors and groups. They are only truly effective as investment vehicles for a day. What existed yesterday has been redeemed and what will be tomorrow has not yet been created. From air ye came and to air ye shall return.

EDITOR’S NOTE: The same concept backs the “maker-taker” trading model, in which exchanges pay high-frequency traders to swell and fade around supply and demand fluctuations. Create and redeem liquidity to stabilize prices. It’s behind global central banks too: create and redeem currencies to stabilize prices. Eradicate market forces from outcomes. It’s…unnatural. No wonder everybody is looking for a miracle.