Are ETFs Evil?

A recent report by the Kauffman Foundation concerning exchange traded funds and their potential role in the May “Flash Crash” has set the investing world abuzz as these wildly popular products have now been implicated as being potentially destabilizing forces in U.S. equity markets.

So are ETFs evil villains or is this report a thinly veiled attempt to discredit a line of products that is proving to be a major threat to the future of conventional mutual funds?

The report is thick and detailed but makes the following points in the Executive Summary:

  • Derivatives known as ETFs are the true culprits in artificially setting stock prices and posing threats to market stability.
  • ETFs are a deterrent to growth company IPOs.
  • ETFs are radically changing the markets to the point where they and not the trading of the underlying securities are effectively setting the prices of stocks of smaller capitalization companies.
  • ETFs are now undermining the traditional price discovery role of exchanges.
  • ETFs pose unquantifiable but very real systemic risks of the kind that were manifested during the flash crash.
  • Rebut the claims that High Frequency Trading Programs contributed to the flash crash and pose threats to market stability.

(Source: November, 8, 2010)

The response to the Kauffman Report was swift and strong, no surprise, from ETF providers like Wisdom Tree whose CEO wrote in an open letter, “WisdomTree is taking the opportunity to respond because we believe the Kauffman report reflects a serious misunderstanding of the structure and operation of ETFs and the increasingly important role they play in world financial markets.”

In my opinion, the Kauffman report is erroneous on several levels and just adds more confusion to the already confusing events surrounding the May 6th flash crash.

Regarding the flash crash, most experts agree that it was, in fact, high frequency trading programs that were at the heart of that problem and the SEC is considering steps to mitigate those problems in the future.

On the points of distortion of price discovery and systemic risk, I would submit that ETFs are still only a small fraction of daily trading volume and ETF assets are less than 10% the size of the traditional mutual fund industry and so would have a very small impact on either price discovery or market stability.

Regarding ETFs being a deterrent to growth company IPOs, I don’t get this one at all ETFs represent a wide range of asset class and styles and small caps are just one of many sectors represented by these funds.

I would also disagree with the premise that ETFs pose systemic risk of any kind since they are openly traded like any other stock on the exchange and represent only a small fraction of daily volume on U.S. and global exchanges.

And finally, to call ETFs a “derivative” is a bit disingenuous since the definition of derivative according to is “a security whose price is dependent upon or derived from one or more underlying assets.” I would suggest that by that definition, one could also call a traditional mutual fund a derivative, as well.

In my opinion, exchange traded funds have opened many new opportunities for retail investors to participate in asset classes that were previously unavailable and they provide a wonderful combination of a single stock and a mutual fund. They are a fast growing asset class and certainly provide serious competition to the traditional mutual fund industry.

However, contrary to the Kauffman Report, I believe that SEC Chairman Mary Schapiro is on the right track regarding high frequency trading programs and their contribution to the flash crash when she recently said, “There is an issue about use of disruptive algorithms that contribute to volatility and instability and whether they should be programmed with certain throttles in them, meaning mechanisms that change the way they operate given what is happening in the markets.”

Without doubt, the causes of the flash crash will be an ongoing discussion, but in my view, ETFs continue to provide investors and traders enormous opportunities for diversification across a wide array of sectors and diverse asset classes.

John Nyaradi is the author of Super Sectors: How To Outsmart the Markets Using Sector Rotation and ETFs.