Wednesday, October 12, 2011

Are ETF's To Blame for Stock Market Volatility?

I am a big fan of exchange-traded funds (ETFs).

Following in the footsteps of index funds, ETF's became popular about a decade ago.

As originally conceived, the ETF concept is simple: offer investors a low cost, tax-efficient way to gain access to a particular market segment without taking the risk of a single security.

There are more than $1 trillion of ETF's now outstanding, so I am not alone in my enthusiasm for the product. Indeed, ETF's and low-cost Vanguard index funds are really the only segments of the financial products markets that have shown significant growth this year.

However, as with any good idea, the ETF concept has been morphing into different product types that tend to be more complex and, of course, more profitable to the provider. There are more ETF's outstanding today than actual stocks, and the number of new ETF introductions keeps growing.

You can now put your hard-earned savings into an ETF that can offer leveraged bets on any or all parts of the markets, for example.

Andrew Ross Sorkin wrote a piece for the New York Times yesterday quoting investment guru Doug Kass as indicating that these leveraged ETF's are partially to blame for the wide swings in stocks prices that we often see at the end of the trading day:

{Kass} says he knows the culprit behind the late-day market swings: leveraged exchange-traded funds or E.T.F.’s....

To Mr. Kass, these E.T.F.’s are the “new weapons of mass destruction.” (His description is an homage to Warren Buffett’s widely quoted line that derivatives are “weapons of mass destruction.”)

“They’ve have turned the market into a casino on steroids,” Mr. Kass said. “They accentuate the moves in every direction — the upside and the downside.”

Mr. Kass... may be right: at the end of every day, leveraged E.T.F.’s have to rebalance themselves by buying and selling millions of shares within minutes to remain properly weighted. If the E.T.F. made money that day, to remain balanced it has to reinvest the proceeds and leverage them again. In many cases, leveraged E.T.F.’s use options, swaps and index futures to keep themselves in balance.

You might consider the E.T.F. the new derivative.

Columnist Herb Greenberg also wrote about ETF's and market volatility in a piece published on CNBC:

ETFs, or exchange-traded funds, which started as a sound idea but, with Wall Street being Wall Street, have all but turned into a monster... even the biggest operator of ETFs, BlackRock, is concerned about the direction some ETFs have taken—becoming too complex and confusing, with so-called double- and triple-leveraged ETFs leading the charge...

With most ETFs mindlessly mirroring various indexes of everything from the S&P 500 to the illiquid stocks of makers of lithium batteries, THEY have become the market. (Stats showing that the market has never been more correlated to itself—another way of saying everybody is trading in and out of the same things at the same time—have never been higher.)

I don't have enough data on the impact of ETF's, or leveraged ETF's, on the market, but it would be interesting to see the numbers.

What I really worry about, though, is an ETF provider that lacks the sophisticated management tools of, say, Blackrock, State Street or Vanguard.

Packaging and managing an ETF is more difficult than it might appear at first glance, particularly in volatile markets.