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A natural ETF experiment

There is a great deal of talk this week about a report from the Kauffman Foundation on the role ETFs are playing in various market pricing distortions and the systemic risks they pose to the financial system. The authors write:

As more ETFs are created, the risk grows that, in the event of a future market meltdown triggered by any number of possible causes, the rush to unwind the ETFs will aggravate any sell-off. Indeed, some creators of ETFs may not be able to honor their obligations.*

Not surprisingly there has been a backlash against this report.  An analysis of the report is beyond the scope of any single blog post (or posts).  Rather than focusing on the details of the report let’s take a step back and conduct a thought experiment.

What is a better test of the ETF industry:  the Flash Crash or the financial crisis?

The authors of the report cite the role ETFs played in the Flash Crash in the cascade of market malfunctions.  The trading (and arbitrage) of ETFs during that time was disrupted by the pricing issues with the underlying securities.  All market participants on that day were impacted.

During the financial crisis when the S&P 500 declined some 58% from top to bottom.  During that time there was little in the way of ETF disruptions.  Indeed some could argue that in a certain respect, i.e. high yield bond ETFs, they served as a price discovery mechanism.  The ETF industry was smaller, in terms of number of funds and assets under management, at that time, but the continued growth in the ETF industry is due in part to its performance over that time period.

In this light the effects of one of the worst bear markets in a century is likely a better barometer of the viability of the ETF structure (and industry) than the effects of a one-day market meltdown.  In fact, only those traders (or investors) who traded during the Flash Crash at disadvantageous prices, that were not canceled, were ultimately harmed by that event.

That is not to say there are not problems with the ETF industry.  As with all financial products the ETF industry seems to be living up to the old motto of MTV:  “Too much is never enough.”  We have written extensively** about the proclivity of the ETF industry to create me-too and poorly designed funds.  One could also argue that the rise of indexing has helped distort the pricing of individual securities.  There is little doubt that the rise of certain ETFs have changed the underlying dynamics of certain markets.  Further one cannot discount the possibility that additional market meltdowns could be exacerbated by ETFs.

All that being said, the rise of the ETF industry has been net-net a boon to investors.  The allocation of assets in ETFs reflect the collective decision of millions of professional and amateur investors alike.  If the underlying prices of those assets are ultimately proven incorrect, then those investors will pay the price.  In the meantime they provide many investors with the means to invest in a wide range of asset classes in a relatively cost efficient manner.  In that respect, the ETF experiment has to-date proven a success.

*pp. 29-30, “CHOKING THE RECOVERY: Why New Growth Companies Aren’t Going Public And Unrecognized Risks Of Future Market Disruptions”, Harold Bradley and Robert E. Litan, Ewing Marion Kauffman Foundation, 2010.

**We should also probably distinguish between exchange traded funds and their cousin, exchange traded products that use derivatives to generate returns.

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