The Impact of ETFs

In previous posts, I've discussed the use of ETF's, and how they can be an effective way for individual investors to easily and cheaply make investment bets while simultaneously gaining instant diversification. The concept of an ETF has been hugely succesful. Just check out the graph on the left to get an idea of how popular they've really gotten. But one thing that has been bugging me for a while now is, with the prolific growth of ETF's, what is their impact on the market? Furthermore, could ETF's be at least somewhat responsible for the increase in market volatility we've seen over the last few years? Well, to help me answer these question, I went to trusty old Google and found a few papers discussing this very topic. The Kauffman Foundation has a really interesting analysis on this, and, for the most part, I agree with it. Blackrock also has a shorter (and certainly biased as it is one of the largest ETF companies in the world) paper on the subject which agrees with some of the points of the Kauffman paper. 

Some Key Highlights and My Take

The Kauffman paper is a pretty long read. But no worries, that's what InvestingDecoded is here for. In a nutshell, the paper makes the following points:

• The emergence of ETF's is detrimental to smaller capitalization companies as the trading of ETF's has an undue influence on the stock prices of these companies and takes focus away from their fundamental values. 
• Some ETF's are invested in instruments that are dangerously illiquid, which can have catastrophic consequences should severe adverse market events occur. 
• The amount of shorting occurring in ETF's is also extremely dangerous and can cause 'flash crash' like situations (see chart on right). 
• The concept that ETF's are immune from severe short-squeezes because you can 'always create new units' is a fallacy.
• ETF's likely have a greater impact on market volatility than High Frequency Trading, the more common suspect in this phenomenon 
• In terms of recommendations, the paper, among other things, recommends:
• Increased transparency on how ETF's are created and structured
• Limits on ETF shorting
• Circuit-breaker rules to prevent severe market moves
• The ability for smaller firms to opt out of inclusion in indices and, consequently, ETF's 

In general, I think the paper has some very valid points. I think the growing proliferation in ETF's has created a somewhat hidden hazard in the market. WIth an ETF, an investor can instantly pour in millions, if not billions, of dollars into a single sector or commodity. It's hard to imagine how this would not have a significant impact on the underlying assets in the ETF. As this occurs, you can potentially impact hundreds of unique assets (e.g. stocks) simultaneously, thereby driving correlations. I'm sure there are plenty of trading strategies out there based solely on making big bets on sectors/geographies/asset classes/commodities using solely ETFs. As ETF's become more liquid and prevalent, this strategies will become cheaper and more impactful to the overall markets. There's no real other way to do this type of trading as effectively. Mutual funds aren't liquid enough and can't be traded intraday. Buying such a big group of stocks/bonds/etc. on your own would be expensive and time-consuming. Other types of derivatives like options or futures can also have liquidity issues. ETF's are truly the quick hit for the markets, and that can have dangerous consequences.

Interesting Tidbits

To further illustrate this point, the Kauffman article had some very interesting tidbits of information that I think are worth pointing out. 

Here's a few of the highlights that I found particularly interesting

In common stocks, heavily shorted stocks are subject to a 'short squeeze' in which a stock's price can rapidly rise to bring out new supply that can be borrows. While 5 percent short interest is considered very high for common stocks, as of June 30, there were six ETFs with more than 100 percent short interest and at least thirteen ETFs with more than 5 percent.

Having more than 100% short interest is a scary stat no matter how you cut it. Yes you can create new units, but how many can you create? What will be the market impact? It probably won't be pretty. 

In other words, on a typical day, more than 37 percent of the entire trading value of the underlying securities trades is in a single small capitalization index ETF (IWM).


Also very interesting. It goes directly to the point that more and more of a given stock's trading is dictated by the acitivity of the ETF related to its index rather than anything related to its own dynamics (whether it be fundamentals or technicals). 

The popular SPDR gold shares, the world's largest gold ETF, holds more than 1,280 tons of bullion, more than most central banks [it's the 5th largest holder of gold in the world!]. Investors have been promised an ability to easily trade an asset whose  long history belies any notion that it is, or should be, easy to trade. Once retail investors decide it is time to sell gold, will sovereign funds stand there with outstretched hands? We think not. 

And I agree. There is a case to be had for creating liquidity where it isn't entirely appropriate to have it. 

Extending The Argument

Although I think both the articles make valid points. There are some things that I think are missing. First, I'd like to learn more about the impact of levered ETFs, the ETFs that mimic an index, but multiply its effect through use of derivatives. Wait, does that mean you're getting a derivative of a derivative? Has that been done before? Did it turn out well? Yes, Yes, and No. Think synthetic CDO's. 

Also, to prove the point in the Kauffman paper, I'd like to see a comparison of trading patterns of small cap stocks that are included in an ETF's vs. those that aren't. Although that comparison may be difficult to make, it may shed some interesting light on the impact of ETFs. 

What are your thoughts?

Questions/Comments/Feedback?Please don't hesitate to let me know of questions or comments you have about this post or any other. If you want me to write about something else investing related, do let me know!

The Standard Disclaimer

Everything I've written above is my opinion and my opinion only. Please do not take it as fact. Perform all necessary research and analysis prior to acting on anything I've said above. This includes consulting a financial advisor.