Are ETFs Dangerous?

A noisy group of over-regulators and stock pickers are braying that ETFs are, among other things, dangerous, flawed, and ruining the markets. With the market turmoil on August 24^th these critics have gained some press traction. But are they correct? Let’s check the facts…

Horses blame cars
Those faulting ETFs for stock market problems are generally from one of two groups with a vested interest in the good old days – active managers who are losing assets to index-based ETFs and regulators looking for a scapegoat when markets move wildly. They are, on balance, backward looking groups, like the horses blaming cars in 1915 for accidents. We know how that one ended.

Consider the scary events of Monday morning, August 24^th of this year when the Dow suddenly dropped 1000 points, or 6 percent. Some ETFs seemed to be in the thick of it. VHT, the Vanguard Health Care ETF dropped 27 percent, trading below its intrinsic value for 30 minutes. It recovered within the hour and ended the day down 3 percent. Critics crowed that the ETFs had driven the market out of synch with reality. The same story floated in the flashcrash of May 2010.

Lost in the outcry is the fact that at the same time individual stocks also traded at unreal prices. GE traded down 21 percent. Even worse, KKR, the publicly traded private equity firm with the same market cap as VHT traded down 60 percent before recovering. There are many more examples. Clearly, market pricing was mis-functioning, period. To blame mispricing on ETFs ignores what happened in individual stocks and simply does not describe reality. It confuses correlation with cause.

Tail wags dog?
When critics say that ETFs cause broad market dislocations in the US markets and trading risks, I wonder what end of the telescope they’re using. Despite their impressive growth over 20 years ETFs are just too small to profoundly affect big markets like US stocks. ETFs hold about 8 percent of US stocks. There are more than 1300 ETFs worldwide with $3 trillion in assets (only about half of these own US stocks). By comparison the ten biggest US companies are worth more than $3 trillion. No one is blaming those ten biggies for market instability. Big as US ETFs are, they are still small fish relative to the United States market as a whole.

Where’s the danger?
When I look for the danger in ETFs, I don’t worry about them fouling the markets or causing severe price dislocations. They just don’t have the market cap to wag that big dog. But what I do see is the misperception of many investors that all ETFs are equally well-managed, economical and worthy of investment. Far from it. In fact, only four percent of the 1700 ETFs now available pass muster for us. Like all investments, ETFs require close examination to see if they actually work. In our eyes, 64 of them do. (Call me for a copy of our menu. I’d be happy to compare it to yours.)

Among the 96 percent that don’t measure up for us, we find ETFs with high expenses, poor tracking of their target indexes, leverage, asset class drift, active management disguised as passive, and other failings that destroy returns and increase risks.

Fact over rumor
Let’s accept the fact that temporary market instability like the flashcrash and the August tantrum can and will happen. Market systems are occasionally unstable, just like the weather. Like it or not, human panic and computerized trading rules can drive prices temporarily insane. But let’s not blame ETFs.

ETFs have much to recommend them when used properly. Done right, they’re rigorous, disciplined, rules-based, transparent, and relentless. Simply put, ETFs are a powerful and disruptive 21st century technology that has helped to democratize the markets. The next time someone cries wolf over ETFs ask them to show you the facts.

John Osbon – josbon@osboncapital.com