ETFs: “Like Handing an Arsonist a Match”

Last week we said that, given the indiscriminant nature of the selloff in stocks, we suspected that exchange traded funds (ETFs) were a driver of the weakness. ETFs are like mutual funds in that they represent a basket of stocks, but they differ in that they can be traded throughout the day (as opposed to a mutual fund being priced one time a day – at the close of trading). This liquidity, combined with exposure to a market index, has made ETFs very popular in recent years.

Our suspicions about ETFs’ role in the selloff last week were confirmed by Empirical Research Partners, who noted that the ratio of trading volume in ETFs relative to that of the entire market was about 42% on August 24, a level not seen for any day since early 2009. Concerns about China’s economy triggered selling in global markets, and the quickest way for professional/non-professional investors to pare exposure to stocks was to sell ETFs. This forced the ETFs to sell shares in all the underlying stocks, which forced the prices of those stocks down.

The popularity of ETFs has grown among market participants who, in the aftermath of the financial crisis, want to be able to reduce market exposure or shift between sectors (sector ETFs offer a basket of stocks in a certain sector or industry) when they sense danger/opportunity. This has driven an explosion in ETF trading volume, even before the recent turmoil. Below are some staggering statistics, courtesy of Bloomberg Business. These numbers were published July 30, before the recent market correction.

US ETFs hold $2.1 trillion in assets.

US ETF trading volume for the last twelve months was $18.2 trillion. This means that the rate of annual turnover for US ETFs was 870%! For perspective, if you replaced each of your holdings in your portfolio once per year, your turnover would be 100%.

By far the most popular ETF, the Spider, or SPY, which mimics the S&P 500 index, had $6 trillion in trading for twelve months. This was four times more than any other security on the planet. The turnover in this security was 3,400%. Again, this was before the recent correction, which saw a spike in volume.

The Inverse VIX ETF, which moves in the opposite direction of the volatility index (VIX) has about $675 million in assets but trades $830 million per day. This means that turnover is 122% daily, or 31,000% annually.

Granted, much of this trading is likely hedge funds using the securities to hedge positions. Then again, the market value of a share of the Inverse VIX ETF declined by half over the course of one week, and it’s hard to believe all the holders were perfectly hedged.

As we mentioned, professional and non-professional investors like the ease with which they can shift strategies with ETFs, especially with the financial crisis still fresh in many minds, and China is just the latest catalyst that prompted many to shift. Of course this type of reactionary behavior has almost surely cost investors more money than it has saved, as caution tends to be greatest at the bottom and every scare over the past six years has proven to be manageable. Like mutual funds or other stock accounts, ETFs can be effective investment vehicles if held for a long period of time. But the “enhancements” they offer – namely the ability to trade – can be dangerous in the hands of most humans, who are physiologically wired to “do something” when they (their financial security) feel threatened. This is why Vanguard founder Jack Bogle said, “An ETF is like handing an arsonist a match.”

Empirical Research Partners has discovered a positive correlation between the volatility index and the percentage of dollar volume that is represented by ETFs. As they write, “when a panic sets in, it’s a lot easier to hit the sell button one time instead of 500 times.” But one wonders if hitting the sell button, or even having the ability to hit the sell button, is right/good in that situation.

Similarly, so-called smart beta strategies, which have grown increasingly popular and which, through an ETF, allow an investor to gain exposure to a basket of stocks with a specific characteristic, such as yield, size, or growth, have seen purchases increase in the strategies after they have outperformed. In other words, if a certain strategy has a strong quarter of performance, that strategy tends to see increased purchases. Unfortunately, there is no relationship between a strategy’s performance in one quarter and the next.

The recent correction has brought to light the role of ETFs in the market, and the volume statistics are mind-boggling. Innovation is generally good, but like many things in life, there is a downside, and we would argue the downside to using ETFs to engage in frequent portfolio repositioning is particularly steep.

Best regards,
Mark Oelschlager, CFA
Co-Chief Investment Officer & Portfolio Manager
Oak Associates, ltd.

© Oak Associates, ltd.

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