Traders Using ETFs in Place of Individual Stocks

October 23rd at 9:01am by John Spence

Much is made of the rivalry between exchange traded funds and traditional mutual funds. However, a bigger and more important trend in the market could be traders using ETFs to make bets on entire sectors rather than individual stocks.

Dave Lutz, an ETF strategist at Stifel Nicolaus, says the ETFs that have become so popular among traders are “cannibalizing” the stocks that they are designed to track, resulting in choppier trading for investors in the underlying shares, reports Matthew Boesler at Business Insider.

At the end of the third quarter, there were 1,465 exchange traded products in the U.S. with total assets of $1.3 trillion, according to BlackRock. The business gathered inflows of $135.5 billion year to date.

As the ETF industry continues to grow at a rapid pace, some have argued that the financial products are boosting volatility and correlations in the market, although such claims are difficult to prove.

Yet one clear trend is that more traders are substituting ETFs for individual stocks in their strategies. For example, they can buy a financial ETF such as Financial Select Sector SPDR (NYSEArca: XLF) rather than an individual company such as Citigroup (NYSE: C) or Bank of America (NYSE: BAC).

The sector ETF is extremely liquid with low fees, and traders can reduce single-stock risk if one company blows up. There are also industry-specific ETFs for technology, utilities, consumer staples and various other sectors.

Lutz says that all of these ETFs purchasing up shares of stocks they’re meant to track is causing the actual, “tradable” float to be a lot smaller than the official number suggests.

“Because there are less shares of certain stocks ‘warehoused’ by ETFs being traded in the market, trading in those names will be less liquid than the ‘float’ number would normally indicate and, as a result, will be more volatile,” according to the BI report.

“Lutz takes his own firm, Stifel Nicolaus, as an example. The official float on Stifel stock is 49.7 million shares. ETFs hold 6% of those shares. Passive index funds hold another 16 percent of SF shares,” it added. “That means a total of 22% of SF shares are being ‘cannibalized’ by the ETFs and index funds that hold them, says Lutz, and investors in individual stocks need to adjust their calculations accordingly, or get caught off guard by unexpected volatility and decreased liquidity.”

The opinions and forecasts expressed herein are solely those of John Spence, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.

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