Market Impact of ETFs and Futures

Editor's note: This was originally published on RealMoney. It is being republished as a bonus for TheStreet.com readers.

Years ago, we had a simpler configuration of derivative and proxy instruments for the markets: index futures and options. More recently, exchanges and sponsors have introduced "emini" futures and exchange traded funds (ETFs), which have broadened the availability of speculative and hedging instruments to an even wider group of investors and traders.

There is much confusion, speculation, lack of knowledge, etc. regarding the impact of ETFs upon the overall market. The introduction of leveraged or "ultra" ETFs has only resulted in exacerbating the mystery of the effect of ETFs upon the indices, including the recent volatility that has gripped the markets from a day-to-day perspective and, more importantly, during the final half hour to hour of trading.

We need to look at these phenomena from three perspectives: ETF construction, trading activity and non-futures-related ETF/stock manipulation.

ETF Construction

ETFs are created by placing assets or total return swaps into a trust. The trust then issues certificates or fund shares that are listed on an exchange in the form of ETFs. Some ETFs are constructed from a combination of assets or swaps. Total return swaps are over-the-counter contracts that specify the exchange of economic values based on the movement of an index or asset between two parties.

For example, a total return swap on the S&P 500 would call for Party A (the payer) to pay the upside price return of the S&P 500 plus dividends to Party B (the receiver). In return, Party B would pay to Party A the downside price return of the S&P 500 plus an interest payment, which is typically pegged to an interest rate such as LIBOR.

A plain vanilla ETF such as the SPDRs (SPY Quote), which is targeted to provide the return of the S&P 500, is constructed by the trust purchasing all of the constituent stocks of the S&P 500. The more complex Short S&P 500 ProShares (SH Quote) is constructed by a combination of short stocks and short swaps, the ETF being Party A in this example.