Client Portals

Are ETFs Dangerous?3 min read

Oct 14, 2015 - John Osbon ( 5 mins to read)

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 24th these critics have gained some press traction. But are they correct? Let’s check the facts…

Horses blame carsgot-skepticism
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 24th 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 –

delivered to your inbox


This communication may include forward-looking statements. All statements other than statements of historical fact are forward-looking statements (including words such as “believe,” “estimate,” “anticipate,” “may,” “will,” “should,” and “expect”). Although we believe that the expectations reflected in such forward-looking statements are reasonable, we can give no assurance that such expectations will prove to be correct. Various factors could cause actual results or performance to differ materially from those discussed in such forward-looking statements.”

“Historical performance is not indicative of future results. The investment return will fluctuate with market conditions.

Past performance is not indicative of any specific investment or future results. Views regarding the economy, securities markets or other specialized areas, like all predictors of future events, cannot be guaranteed to be accurate and may result in economic loss to the investor.

Investment strategies, philosophies, allocations and holdings are subject to change without prior notice.

This communication is intended to provide general information only and should not be construed as an offer of specifically tailored individualized advice.

While the Adviser believes the outside data sources cited to be credible, it has not independently verified the correctness of any of their inputs or calculations and, therefore, does not warranty the accuracy of any third-party sources or information.

Adviser does not endorse the statements, services or performance of any third-party vendor.

Unless stated otherwise, any mention of specific securities or investments is for hypothetical and illustrative purposes only. Adviser’s clients may or may not hold the securities discussed in their portfolios. Adviser makes no representations that any of the securities discussed have been or will be profitable.

Any IPO alerts are purely informational and should not be construed as recommendations to invest.

Adviser is not licensed to provide and does not provide legal, tax or accounting advice to clients. Advice of qualified counsel or accountant should be sought to address any specific situation requiring assistance from such licensed individuals.

Any case studies or hypothetical client profiles are for demonstration purposes only. They illustrate the breadth and depth of the many clients we represent at various life stages. Any similarities to actual Adviser’s clients past or present are strictly coincidental. Individual advice and results will vary based on each client’s circumstances, objectives and prevailing economic conditions.