The Conflict Of Interest Behind The Kauffman ETF Report

Tyler Durden's picture

By now, everyone has heard about the Kauffman report on ETFs, whose sole purposes is to bash exchange traded funds, which if nothing else, are aggressively stealing market share from mutual funds. The report also tangentially makes a claim that HFTs are in fact innocent, and had no role in the flash crash. While ETFs are certainly not without fault, to say the High Frequency Trading is irrelevant for market crash purposes is naive beyond measure. Yet a more salient question is where did the anti-ETF bias arise at Kauffman, and what is the point of this hit piece out of left field. We decided to dig a little deeper, and found the following conflicts of interest.

A little background, the Chairman of the Kauffman Foundation is one Thomas McDonnell. Here is his bio:

Thomas McDonnell has provided leadership and insight as a Kauffman Foundation trustee since joining the board in 2003. He was elected Chairman of the Board of Trustees in September 2006.

He is president and chief executive officer of DST Systems, Inc., headquartered in Kansas City, Missouri. McDonnell has worked with the company since March of 1969, and served as president since 1973. DST is a leading provider of information processing and computer software services and products to the financial services, communications and healthcare industries. Today, DST operates offices in 14 cities worldwide, employing approximately 8,500 associates domestically and 1,500 associates internationally.

So let's take a look at DST (highlights ours):

DST is Experience

Founded in 1969 as a division of Kansas City Southern Industries, DST was established to develop an automated recordkeeping system for the mutual fund industry. DST has supported the industry’s continued growth and is the largest provider of third-party shareholder recordkeeping services in the United States today.

Headquartered in Kansas City, Missouri, DST is a publicly traded company on the New York Stock Exchange (Symbol: DST) that employs approximately 11,000 associates, both domestically and internationally.

DST is Technology

DST’s products and services are enhanced by the integration of advanced technology and e-commerce solutions. At the heart of this are DST’s Data Centers, including the Winchester Data Center.

Winchester offers state-of-the-art facilities, hardware, maintenance, and support.
Its computers can process more than 25,000 million instructions per second (MIPs). Staffed 24 hours a day, 7 days a week, 365 days a year, Winchester has a self-contained power plant and is designed to withstand tornado force winds without interruption.

And this:

As a consistent leader in providing innovative solutions and
comprehensive services, DST also provides the technology infrastructure
to support millions of accounts for mutual fund companies
, healthcare
providers, banks, and insurance companies around the world.

The DST Data Centers enable you to focus on your core business processes
while DST manages the technology infrastructure helping
you reduce total
cost of ownership, system maintenance costs, information technology (IT) resources, and capital
budget expenditures.

In other words, the core of DST's business model, and thus McDonnell's wealth, is a reliance on the old mutual fund business model, on providing scalable tech infrastructure for HFTs, and on pretty much everything that bashing ETFs will achieve, while attempting to cast HFTs in an agreeable light. Is there a pattern emerging here?

Yes, one can goal seek our broken market's data to suit pretty much any purpose, and conclusion. Let's not forget that the SEC claimed HFTs had no involvement in the flash crash, despite, as Nanex and Zero Hedge pointed out, it was precisely they, and not Waddell and Reed that were responsible.

And while there is a glaring conflict of interest behind the Kauffman report, that does not mean it is wrong. In fact, it merely confirms what we have been saying for almost two years. That the market is broken. But don't take our word for it. In a recent interview with Securities Technology Monitor, Larry Leibowitz, COO of NYSE Euronext said, and we quote, "I think most of the world views our market structure as kind of a joke, to be completely honest.’’ In this context is it important if HFT of ETFs are a bigger culprit? Of course not. When the entire game is rigged, rampant cheating is permitted, and overall topology is, well, broken, none of it matters one bit.

h/t Nicholas Colas

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DollarDive's picture

One of the main claims in the report is that the excessive short interest in the ETF's could result in a meltdown....This claim seems to be realistic, taken within the context that there could be a conflict of interest too.  I'm curious to hear Tyler's analysis of the huge short interest and whether or not this carries any weight.....Tyler ? 

Tyler Durden's picture

ETF = synthetic CDOs. Nothing more, nothing less. One asset, with theoretically infinite layers of claims attached to it (as long as the longs and shorts at any level net out). It is of course a house of cards waiting to topple, but so is everything else in this market.

Bartanist's picture

Thanks for posting ... answers my question below. I now agree that the world has no real need for these Las Vegas style proposition gimmick bets because they distort supply and demand and free markets.

HCSKnight's picture

Tyler, sorry but your statement as written is simply not true; e.g. the IWM holds only the underlying securities.   Maybe you want to clarify your comment with regard to the different types of ETFs, i.e. inverse and "x" ETFs..... and also with regard to primary vs. secondary markets and their derivatives.

KidDynamite's picture

DollarDive - a meltUP is a much more likely scenario than a melt-down.  The big risk from excessive short interest is short squeezes.  The Kauffman report massively errs in understanding who would get hurt there.  IndexUniverse wrote a good piece on it:

 

http://www.indexuniverse.com/sections/blog/8376-kauffman-report-on-etfs-...

 

In any case, this is about stock loan procedures - not ETFs in particular.

 

DollarDive's picture

Thanks Kid.  I'll check it out.

Bigger Dickus's picture

All comments suddenly disappeared...weird

Bartanist's picture

A serious question: Do ETFs actually own the assets or only track the assets in the way that CDOs tracked MBSs?

Excuse my ignorance, but the triple short and other gimmick bet ETFs make me think that ETFs are just junk bets. If this is the case, then I would agree that ETFs are junk and should not exist because they distort supply and demand and allow for abuse and manipulation. However if an ETF is an actual owner of the equities, as a mutual fund is then I have no problem with low cost competition to mutual funds... that is evolution.

ZeroPower's picture

Most ETFs (unless otherwise noted in the prospectus) synthetically track their 'target' using derivatives - swaps, futures, etc.

Bigger Dickus's picture

God, please smack gold bugs across the face and blow them off the water so I can buy more at low prices.

Cvillian's picture

.....aaand the neighboring company on our floor continues buying screens in a juvenile attempt to recreate the "Flight of the Navigator" spaceship interior whilst simultaneously destroying any chance that fundamental investment will prevail in this market.

"We're doing 3-4% of NYSE volume," he gloats in the elevator the other day. Guy has no idea what he's doing and I can't wait for each of his 50 LCD screens (that are crammed in the 300 sq ft of space they occupy) to be given away to anyone willing to haul it away. Sadly, I'll probably be out of a job before that day occurs.

Jones79's picture

only in money management are ad hominem arguements valid since truth value is not the yardstick by which claims are made or measured. 

Insiderman's picture

You might check into the mutual fund company started by the Kaufmans (cough... American Century).

paragshah12's picture

One important category of ETFs is leveraged ETFs. Carries very high risk and one shouldn’t treat these the same as a normal ETFs.

http://www.financemetrics.com/exchange-traded-funds-and-common-misconceptions/