Exchange traded funds have been accused of being the reason for some of the wild market swings that occur. Are these funds the real culprit behind market volatility?
ETFs have gained popularity over the years, due to their diversification benefits and low cost. The flexibility to trade a basket of stocks throughout the day is enticing for many. According to Investment Company Institute data, there are more than 1,110 ETFs trading in the U.S., up from about 200 that traded in 2005, reports Scott Cendrowski for CNN Money. Furthermore, ETFs now account for 30% of trading volume on U.S. exchanges.
“As these products have increased, correlations have been increasing every year,” Harold Bradley, chief investment officer of Ewing Marion Kauffman Foundation, said. However, there is no hard evidence that ETFs are the cause for market volatility.
ETFs are an easy case to take the blame because they are relatively new on the scene, but much of the ETF trading that takes place never results in the actual buying and selling of the funds’ underlying stocks, says Morningstar. The actual basket of shares are trading but the contents, or stocks within, don’t actually trade. [Using ETFs to Gauge Market Sentiment]
Inverse, or leveraged ETFs have also been put under the spotlight because of their use of derivatives to pump up bets. These instruments “corrupt the markets by exacerbating price trends” both up and down, Doug Kass of Seabreeze Partners said in a previous article on Real Money. Both the SEC and FINRA have held investigations to find if these funds are to blame, as well as the U.S. Senate subcommittee. [Leveraged or Inverse ETFs: What You Should Know]
Most of all, the ETF industry is still small in comparison to stock futures and options. “They’re too small to have outsize effects in the $17 trillion U.S. equity market,” Jason Hsu of Research Affiliates said.
As far as market volatility, who or what is to blame? Cendrowski proposes that it could be agitated investors reacting to the European debt crisis, weak U.S. economy and slowdown in emerging markets. Morningstar analyst Michael Rawson reports that company profits could also be driving the mania. During periods of higher earnings volatility, stock volatility is known to spike. There is simply not enough proof that ETFs are the root of the problem. [Are Rising Correlations Affecting ETF Correlations?]
Tisha Guerrero contributed to this article.