There was a good piece in the WSJ today discussing potential “flaws” in Exchange Traded Funds (ETFs). ETFs are a relatively new product that have amassed huge quantities of assets in the last few decades but are still dwarfed by the mutual fund space (roughly 2.1 trillion in assets vs 12.6 trillion in mutual funds). The SEC recently said “It may be time to re-examine the entire ETF ecosystem.” That sounds a bit hyperbolic to me. But it’s a concern in many circles even with indexing advocates such as John Bogle. But it’s important to understand that ETFs aren’t dangerous unless you misunderstand them or misuse them. Unfortunately, a lot of behavioral bias appears to be driving the misguided fears about ETFs. Let’s dig in a little deeper.
1. ETFs can be dangerous when misused. The first ETF founded in 1993 was the SPDR SPY which was designed to track the S&P 500. It’s a remarkably tax and fee efficient product that has served its investors very well since its founding. This was a very simple product designed for passive indexing, but the ETF space has morphed substantially since 1993. Much like the mutual fund space, it has morphed from a simple indexing product into a series of products that feed investor impatience and desire for rapid profits. And so we’ve seen a substantial surge in “active” ETFs, leveraged ETFs, “hedged” ETFs and other similar products. Many of these products abuse the efficiencies of ETFs by being tax inefficient and fee inefficient. They sell the diversification of indexing, but saddle investors with all the negatives that result in higher fees, tax inefficiencies and poor performance.
I’ve written substantially on the dangers of leveraged ETFs and how fund companies sell high fee closet indexing ETFs in exchange for empty promises about hedging and “market beating” returns. These products, in my opinion, are often dangerous and sold on false premises. But that does not mean we should make sweeping generalizations about the entire ETF space. The fact that some ETFs are bad does not mean they are all bad.
ETFs are dangerous when misunderstood and misused. As Warren Buffett says, never invest in something you don’t understand.
2. ETFs traded precisely as they should have during the August Flash Crash. One of the primary drivers of the fears around ETFs was the morning of the Flash Crash in August when many ETFs declined by 30-40% for no reason. We should be really clear about what happened earlier this year during the Flash Crash. ETFs traded precisely how they should have during this event.
ETFs are liquid trading instruments designed to reflect the aggregate performance of their underlying holdings. On the morning of the Flash Crash there were a huge number of stocks that were halted or illiquid. An ETF trades with a market price (the price you see) and an intra-day indicative value (the price the market maker sees). The market maker will try to keep the IIV as close to the market price as they can by making a market in the ETF. But when most of the underlying holdings are halted there is no reliable IIV and so the price of the ETF is basically unknown until the underlying holdings open again. This problem was exacerbated during the Flash Crash because there are fewer human traders there to identify the sorts of issues that I identified in real-time:
Tons of ETFs trading at incorrect prices getting filled. This is like Xmas.
— Cullen Roche (@cullenroche) August 24, 2015
Unfortunately, a lot of people didn’t understand this or implemented stop loss orders that resulted in sales well below where the ETF should have actually been trading. I watched this happen in real-time and was even able to execute buy orders at a 25%+ discount due entirely to these behaviorally biased investors. Make no mistake – this was not a flaw in the way ETFs work. It was purely user error.
ETFs are not inherently dangerous, but like many investment products they can be abused by people who don’t understand them or misuse them. This isn’t a product flaw. It is a human flaw as old as the financial markets themselves. If you want to better understand ETFs I recommend reading the following primer from ICI or this one from BlackRock. Well informed is well armed.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.