Toxic Bloom: How the unexamined dangers of ETFs threaten investors and the efficiency of markets

Linked above is the latest whitepaper from Taylor Frigon Capital Management, entitled "Toxic Bloom: How the unexamined dangers of ETFs threaten investors and the efficiency of markets," published on August 27, 2015.

In it, we compare the massive growth of exchange-traded funds (ETFs) within financial markets to a runaway "toxic bloom" of algae within a body of water, citing evidence which suggests that ETFs by their very nature may have extremely damaging effects on financial markets, impacting everyone who relies on those markets, whether investors in ETFs or not.

Back in July we published a post discussing several longtime concerns we have had regarding ETFs, especially in light of some high-profile comments by well-known investor Carl Icahn, who was himself raising a warning about ETFs (and specifically about ETFs designed to try to track inherently illiquid securities such as high-yield bonds).

At the time we wrote that July post on ETF dangers, we decided that we should also publish a more extensive "whitepaper" discussing the specific aspects of ETFs which we believe are potentially hazardous, and providing some explanation of just how ETFs are basically structured.  

A big part of the reason for writing such a paper: we don't believe investors in general have a very good grasp of exactly what an ETF really is, and how it is related to the so-called "basket of securities" to which it purports to provide investment exposure. 

In fact, we actually believe that very few financial advisors who employ ETFs as part of the strategy that they recommend to clients fully understand ETFs, or understand the fact that the only linkage between the price of the ETF that they recommend to their clients, and the market value of the "basket of securities" that the ETF is supposed to be tracking, consists of the willingness of certain big financial firms to engage in arbitrage-driven trading activity.

Just as we were completing this paper, and before publishing it today, new evidence emerged which illustrated this phenomenon rather dramatically. During the plunge of the US stock markets at the open on Monday, the price of many ETFs plunged far more than the drop in the market value of the securities that they were supposed to be tracking, coming "unhinged" by a wide margin and causing serious consternation among those who owned shares in those various ETFs (here is a story discussing this ETF disconnect in the Wall Street Journal -- and there are many others).

The drop was so severe -- and the "gapping downwards" so rapid during the day -- that many investors and financial advisors who had placed stop orders and market orders to sell had those orders execute at percentages below the price they thought they would get for the trade, by 20% or more in some cases. The fact that many financial advisors placed stop-loss orders on these ETFs, and the fact that some are quoted in that article as saying the price drops and gapping of the ETFs that they saw that day "don't make any sense," tends to confirm the allegation that many financial advisors do not actually understand the principles of arbitrage and liquidity upon which ETFs by their nature must depend in order to keep the price of the ETF in line with the price of some basket of securities.

When liquidity becomes scarce -- or when the big Wall Street firms who are authorized to make those arbitrage trades for the ETFs decide to "step aside" and not make those trades (for whatever reason, usually because they see that there is not enough liquidity) -- then the price of the ETFs become unhinged in exactly the manner that was witnessed on Monday. 

In other words, that kind of "gapping" makes perfect sense: it is a product of the well-known laws of supply and demand, and is generally the way that prices will move in a market from which liquidity vanishes.

We believe that the tremendous growth of ETFs poses significant hazards -- and academic papers cited in the above whitepaper suggest that these hazards may in fact impact the wider market and not just ETFs. 

We believe that understanding how ETFs work is an important step towards trying to address some of these hazards.

A Hissy Fit In The Market

The market opened this morning in a very chaotic manner which is indicative of the kind of reaction that comes from a market which is dominated by trading and non-economic decision-making versus investment based in business fundamentals.  Quite timely given our commentary recently about the disfunction caused by the ETF phenomenon.  Incidentally, even the talking heads on CNBC were referencing the potential that ETFs could be at the heart of the "dislocation" that seemed to be occurring in the trading apparatus this morning.  

Who really knows?  And that is not comforting!  

However, it is not as if we haven't seen panic-type markets before.  We experienced the one day drop of 22% in the DJIA in 1987 and the wild swings in 2008-2009; much more severe than today's move.  And since then there have been several "headline events" such as the Greece debacle, Dubai Ports World, disruption in Cypress, geopolitical tensions in the Middle East, just to name a few.  This underscores the need to be centered on a long term investment approach, similar to that which we provide.  One which is based in sound fundamental research and is not dependent on the move in stock prices on any given day, week, month, quarter or year, for that matter!

Ironically, this down move across the board is happening at a time when we think some of our most important themes are showing signs of kicking in after being on hold for the last couple of years.  These would include the transformation towards virtualization across the data center universe, the advent of sensor technology in wearables and the "Internet of Things" (IoT), the transformation of the enterprise into a fully cloud-based platform, and others.  

These are just some of the business innovations that we are focusing on at this time.  We expect that regardless of where the markets ultimately settle today, this week or this month, these trends are and will continue to be powerful drivers of business and ultimately portfolio returns in the years ahead.

That said, we have warned in previous commentary that the market may throw a "hissy fit" when the Fed decides to finally raise the target for the Federal Funds Rate from zero.  This may be that "fit"!  Followers of our commentary know that we have been advocates for raising rates for some time and it would seem the Fed is finally ready to acquiesce.  While it is impossible to say that when the Fed meets in September they will definitely raise rates, it is likely to happen by the end of the year.  Will there be more market turmoil when the event finally comes to pass?  Possibly, but likely the "return to  normalcy" that a Fed rate hike would bring will ultimately allow the market to move higher as it turns its focus back to business, where it belongs.

Whether or not recent market weakness is solely due to the expected actions of the Fed, or China's so-called meltdown, not all that unusual for a market that has had a meteoric rise in just a matter of months, the key is to be centered and still in volatile times, and even look to buy great businesses while they are on sale!