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.   

Concern #5: ETF Cause Higher Price Volatility and May Magnify the Impact of Shifting Market Sentiment
There are also compelling arguments on both sides of this argument.

Fixed income ETFs are at the center of some concerns about volatility. Many of the bonds held in fixed income ETFs trade infrequently, and are often assumed to be less volatile than the ETFs that hold them. 

In many cases, ETFs represent a faster mechanism for price discovery, reflecting price moves before prices adjust in infrequently traded holdings.  

Although it may seem that the ETF is “causing” the underlying assets to decline, the ETF may be the earliest signal of a change in market sentiment. After a lag, the change in sentiment often becomes apparent in pricing of the underlying assets.

Concerns about the degree of momentum-oriented speculation in ETF trading are too significant to ignore, however, as the volume of speculation in market segments such as high yield bonds and small cap value stocks appears to be creating imbalances in the market and potential distortions in pricing.  

ETFs Promote Excessive Trading
John Bogle, founder of Vanguard, is a vocal critic of ETFs. One of Bogle’s loudest criticisms is that ETFs make it easy for investors to trade excessively. ETFs certainly make it easy to trade, but investors were guilty of trading too much long before ETFs were created! 
Charley Ellis, a legendary thought leader about investing, has been vocal for decades about the perils of trading too much. Although ETFs contribute to excessive trading, 24-7 television coverage of the markets, the ease of electronic trading and low trading costs also reinforce the short attention spans of many investors. 

Much of the trading in ETFs that appears to be speculative or tactical in nature is in actuality part of a sound, long-term investment strategy. 

For example, mutual fund portfolio managers frequently use ETFs to “equitize” cash coming into their funds. The ETFs provide short-term market exposure until the mutual fund is able to deploy the cash into longer-term holdings. Shareholders benefit from reduced cash drag, and from a more patient and often lower-cost deployment of the cash into individual securities. 

In my view, the use of ETFs to “equitize” portfolios provides a “win-win” for mutual fund shareholders, even though the rapid trading in and out of the ETF looks like speculative market timing to critics. ETFs are also commonly used for tax loss harvesting, with ETFs used as an interim investment vehicle after taking losses in stocks or actively-manager mutual funds. 

ETFs are often cheaper and more tax efficient than mutual funds, while providing transparency of holdings and the ability to trade throughout the trading day. Trading in ETFs is, in a sense, more democratic, as buyers and sellers of ETFs pay the trading costs associated with their activity. In contrast, buyers and sellers of mutual funds have their trading costs absorbed in part by the other shareholders of the fund.

ETFs, like most product innovations, have positive and negative aspects, and it isn’t uncommon for popular new products to have a “dark side.”

ETFs have their dark side, but if “handled with care” offer many possible attributes.