ETFs have been gaining attention – both good and bad – with some naysayers arguing that the nifty investment vehicle has contributed to heightened market volatility. Don’t believe everything you hear.
Gregory Davis, chief investment officer of Vanguard, on Financial Times argued that there are a handful of reasons why index investing is not the source of a jittery market.
“The surging popularity of index tracker funds makes them an easy target, particularly as the potential cause of an event that has not yet happened. But that is not a valid reason to point the finger at them. If anything, these current criticisms reveal confusion about the nature of both markets and indexing,” Davis said.
Firstly, Davis pointed out that volatility and bear markets pre-date index investing as market crashes and corrections were a part of a healthy financial market long before the invention of index funds. The first such passive fund may be traced back to mid-1970s, or long after the famous stock market crash of 1929 or so-called Great Crash.
“The underlying causes of major market downturns usually lie in a combination of macroeconomic imbalances and speculative investing,” Davis said.
There is no real discernible correlation between growth of indexing and market downturns – index funds attracted net inflows in both up and down markets.
Moreover, Davis argued that index funds are only a smart part of the overall financial market, making up about 10% of the value of global equity and bond market capitalization and even less of trading volumes.
While some critics argued that a major sell-off could trigger massive redemptions with a hoard of investors running for the exit, Davis also reminded investors that in both the 2000-02 and 2008-09 drawdowns, investors were piling into index funds, which experienced heavy inflows.
“You could make the case that these ready-made portfolios were viewed as attractive safe harbours during tumultuous times precisely because they are often low cost and well diversified. But I think that growth was part of a structural trend. More and more long-term, buy-and-hold investors are switching to index investing,” Davis said.
Lastly, ETFs’ structure or the way they trade has no direct impact on the price of the underlying investments, which means they aren’t driving market volatility. Vanguard research found that for every $1 in ETF trading volume on exchanges, less than 10 cents resulted in primary market transactions in the underlying securities. In other words, over 90% of ETF trading did not trigger buy or sells in an ETF’s underlying components.
For more information on ETFs, visit our ETF 101 category.