Are ETFs Breeding Systemic Risks?

ETFs continued to take market share from mutual funds in 2016, extending a painful multi-year trend for mutual fund companies. More than $3 trillion of assets are invested in ETFs globally, and ETFs represent more than 25% of daily turnover on U.S. stock exchanges. The success of ETFs hasn’t come without controversy, as ETFs are increasingly facing a backlash from critics who claim that ETFs create systemic risks for investors. 

Some of the concerns are valid, while others have less merit: 

Concern #1: ETFs Cause Flash Crashes 
Concerns about China led to a deluge of pre-market sell orders in the U.S. on the morning of August 24, 2015. The imbalance between buy and sell orders disrupted the market opening, with trading in an unusually high number of stocks delayed or halted.  The ripple effect for ETFs was severe, as prices for many ETFs decoupled from underlying net asset values. ETFs were more victim than perpetrator, as the disorderly opening of the stock market was the underlying cause of the flash crash.

The flash crash provides important lessons for investors, however, most notably illustrating the importance of good trading practices.  
The first 15 minutes of trading is typically when spreads are at their widest, quotes are thinnest and volatility is elevated. Professional traders are like sharks in the water, and the sharks dominate trading in the beginning and end of the trading day. Often the prudent course of action is to stay out of the water and avoid the sharks, particularly on the most turbulent days! 

We recommend using limit orders rather than market orders, and suggest that most investors avoid trading during the first and last half hour of the trading day. 

Concern #2: Some ETFs Are Dangerous; Others Ill Conceived
Inverse and leveraged ETFs are among the ETFs most frequently cited as being harmful to investor health. Inverse and leveraged ETFs are designed as trading and hedging vehicles for very short-term holding periods. Both may be unsuitable for buy and hold investors, as the longer the holding period the more that compounding can distort returns. 

Other ETFs are more silly than dangerous. The world may not need ETFs such as the Whiskey & Spirits ETF (WSKY), a $2.5 million ETF with 19 holdings, an expense ratio of 0.75% and wide trading spreads. 

Unfortunately, the ETF industry doesn’t have a monopoly on products misunderstood by the public or on ideas that sound good to product marketers but offer little benefit to the investing public. Mutual funds had a multi-decade head start on ETFs, and there are many examples of mutual funds that were failures in design or execution. Although ETFs and mutual funds come with a different product structure, they share many similar pathologies!

Concern #3: ETFs Cause Rising Correlations
Asset classes deviated from long-term trends long before ETFs existed. Correlations spiked during the global financial crisis, but similar spikes occurred when the dot com bubble burst, on Black Friday in 1987, at the start of World War II and during the Great Depression. 

The common theme is that major events or panics cause investors to buy and sell in lockstep with one another.  

ETFs may contribute to the propensity of correlations to spike more rapidly during major events, but in recent years correlations seem to have returned to more normalized levels despite the popularity of ETFs. If ETF growth continues at the current pace, a more permanent increase in correlations may be a more reasonable fear. 

Concern #4: ETFs Create the Illusion of Liquidity in Asset Classes That Aren’t Liquid
There are compelling arguments on both sides of this argument. High-yield bonds and bank loans are among the less liquid asset classes commonly used by ETF investors, and frequent trading may increase systemic risk during a liquidity crisis. High yield and bank loan mutual funds are also vulnerable to a liquidity crisis, but have redemption fees and other policies to discourage frequent trading.

ETF proponents argue that ETF trades typically match buyers and sellers on the open market, and don’t require transactions in the underlying holdings of the ETF. In contrast, mutual funds faced with large redemptions are often forced to sell underlying investments, which can be difficult with less liquid holdings. 
The highest-profile liquidity problem in recent years came from a mutual fund investing in distressed debt, not from an ETF.