Are Exchange-Traded Funds Really Ruining the Market?

In my opinion, no, that’s ridiculous. As I wrote in my book back in 2007, I believe ETFs are one of the best financial innovations to hit the market in decades, perhaps since the mutual fund made its debut. ETFs allow investors to own broad, diversified portfolios at low annual costs. That’s what mutual funds offered back in the day but people ultimately realized that some fund expenses weren’t so low and the performance wasn’t so hot. I believe ETFs offer a solid way to own a passive portfolio which covers a broad cross-section of the market. Couple that with the fact that they are transparent, trade on exchanges like stocks, and are tax-efficient. Now to clarify, when I refer to ETFs, I am referring to large, popular indexes such as the S&P 500* which do not employ leverage. Please read on to hear some professional opinions about how ETFs may have contributed to market volatility:

In late 2011 Eileen Rominger, the SEC’s director of the Division of Investment Management testified to a Senate panel about ETF-related issues. The major issues she covered were about the adequacy of investor disclosure, liquidity levels and transparency of the underlying instruments in which exchange-traded products invest. She also said her staff was looking into the correlation between market volatility and the recent surge in popularity of exchange-traded products. While the findings of that research are yet to surface, Scott Burns, the director ETF Research at Morningstar commented that if the SEC is looking at the same data they are, they won’t find anything substantive about ETFs affecting market volatility. In fact, the majority of panelists at the Senate hearing agreed that many other market factors far outweigh ETFs when it comes to contributing to market volatility.

I also watched an interview between Scott Burns and Leland Clemons, a managing director at iShares, about ETFs and market volatility. Clemons was in agreement that macroeconomic factors including Europe and heightened uncertainty about the US economy were bigger factors contributing to market volatility than the prevalence of ETFs. Clemons goes into detail about the average trading volume of the underlying holdings of the major ETFs and how, on a daily basis, it’s still a very tiny number. The example he gave was the S&P 500 ETF accounting for 1% of the average trading volume of its underlying holdings. He argues that wouldn’t be the sort of factor that would explain a huge jump in volatility. Not to mention, there are both buys and sells (or creations and redemptions) each day – which would act to neutralize the effects that 1% had on market volatility.

If I had to summarize the findings of the many experts that I’ve heard speak on this topic over the past few months, the agreement is that leveraged and inverse-leveraged ETFs are producing more of the problems in the market than regular buy-and-hold ETFs which retail investors have been embracing.** And those problems aren’t all related to volatility, they are often related to the bleeding effect which that leverage has on the performance of those funds over longer period of time.

All of these things are under regulatory review but many think the findings won’t be anything near the dramatic rhetoric which calls ETFs ‘financial instruments of mass destruction.’ In the end, investors want to find answers, in this case, someone or something to blame for the enhanced market volatility. Time will tell but in the short run, let’s not knock too hard on a product which has served well for investors.

As always, feel free to e-mail me with comments or questions.

Russell Bailyn

Wealth Manager
Premier Financial Advisors, Inc.
14 E 60th Street, #402
New York, NY 10022
P: 212-752-4343 *231
F: 212-752-7673

*The S&P 500 Index consists of 500 stocks chosen for market size, liquidity, and industry group representation. It is a market-value weighted index (stock price times number of shares outstanding) with each stock’s weight in the index proportionate to its market value.

**An exchange-traded fund that uses financial derivatives and debt to amplify the returns of an underlying index is referred to as a leveraged or inverse-leveraged ETF. These funds do not amplify the annual returns of an index; instead they follow the daily changes.
Equity-based ETFs are subject to risks similar to those of stocks; fixed income ETFs are subject to risks similar to those of bonds.

Investment returns will fluctuate and are subject to market volatility. Shares may be worth more or less than their original cost when sold.
Although exchange-traded funds are designed to provide investment results that generally correspond to the price and yield performance of their respective underlying indexes, the trusts may not be able to exactly replicate the performance of the indexes because of trust expenses and other factors.

Investing in mutual funds involves risk, including possible loss of principle.

Investors should carefully consider a fund’s investment goals, risks, charges and expenses before investing. To obtain a prospectus, which contains this and other information about a fund, you may contact your investment representative or call the investment company directly. Please read the prospectus carefully before investing or sending money.

Securities and certain investment advisory services offered through: First Allied Securities, Inc., a registered Broker/Dealer. Member: FINRA/SIPC. Premier Financial Advisors, Inc. is a Registered Investment Advisor. First Allied Securities & Premier Financial Advisors are not affiliated entities.

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