ETFs Are Exacerbating Market Volatility

Published in Forbes April 28, 2020
Written by Gerry Frigon
Forbes Finance Council

Capital market mechanisms are in danger of destruction by the hidden byproducts of exchange-traded funds (ETFs), and passive vehicles in general, that have spread across the system. The primary problem is these vehicles claim to provide liquidity where liquidity doesn't exist, thereby exacerbating volatility and limiting "natural" liquidity in the underlying securities that make up ETFs. While I would not necessarily advocate outlawing ETFs, I will say that there is a public interest in protecting capital markets.

My firm and I have spoken out for years about the potential systemic dangers of the ETF craze, and we haven't been the only professional investors to sound this alarm (see Carl Icahn's statements on this subject over the years).

ETFs have been portrayed as benign, investor-friendly products that help the average investor get "one up on Wall Street" by giving one a low-fee investment vehicle tied to an index, with complete liquidity. But in reality, the spread of ETFs/passives is choking the market mechanism and creating added volatility that costs investors in entirely different ways. 

The mechanism of an ETF is complicated (even though it is portrayed by ETF marketers as a friendly "basket of securities"), and it involves arbitrage to keep the price of the ETF shares aligned with the net asset value, or NAV, of the underlying assets. This mechanism occasionally results in startling divergence of ETF share price from NAV, but although those events grab headlines, the bigger concern is the fact that even in normal conditions, the arbitrage function is necessarily done by computer algorithms on an automated basis. Further, as ETFs have proliferated over the past three decades we have now reached a point where more than half of all trading volume is driven by ETF/passive algorithms. Some traders we speak with believe the percentage may be closer to two-thirds.

The dominance of trading volume by ETFs/passives magnifies volatility in the markets, but at the same time, it has not resulted in increased liquidity. On the contrary, I have seen a massive drying up of liquidity in individual companies, which is difficult to explain and not fully understood, even by professional traders I speak to on a daily basis. So, ETFs are adding tremendously to volatility (through the algorithms that are a necessary aspect of the way ETFs are constructed) while not adding the liquidity that their supporters like to claim ETFs provide — certainly not in the underlying securities they supposedly "invest" in. ... CONTINUE ON FORBES

Disclosures: Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Taylor Frigon Capital Management LLC (“Taylor Frigon”), or any non-investment related content, made reference to directly or indirectly in this blog will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this blog serves as the receipt of, or as a substitute for, personalized investment advice from Taylor Frigon. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. Taylor Frigon is neither a law firm nor a certified public accounting firm and no portion of the blog content should be construed as legal or accounting advice. A copy of the Taylor Frigon’s current written disclosure Brochure discussing our advisory services and fees is available upon request. If you are a Taylor Frigon client, please remember to contact Taylor Frigon, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services.

Investment Climate April 2020: Crazy but insightful times!

As we write this quarter’s Investment Climate, hunkered down under orders from authorities to “shelter in place” in an attempt to “flatten the curve” of the COVID-19 virus outbreak, we can only describe the current investment climate as unprecedented.  We have already spent a fair amount of writing time penning comments on our views about the situation, so we urge readers to check out our Taylor Frigon Adviser blog for more detailed commentary on the crisis.

However, for purposes of setting the tone, and to give a sense of where we are coming from on the topic, suffice it to say that we believe this whole situation will turn out to be one gigantic “unforced error” with regard to government response to circumstances the world over.  Maybe we will be proven wrong.  We don’t think so.  But it really doesn’t matter at this point.  Our responsibility is to evaluate the investment merits of companies in which we invest our own and our clients’ hard-earned capital.  On that front, this crazy time has been very insightful.

As a recap of the first quarter, disappointing as it was, our growth strategies weathered the storm of the first quarter relatively well.  Our flagship TFCM Core Growth Strategy was down roughly in line with the large capitalization S&P 500 index and handily outperformed the major mid-cap and small cap indices (given that our portfolios are mostly small and mid-sized growth companies, we are pleased with that). 

Strangely, the worst performing strategy was our Income Strategy.  And even more strangely, some of the worst performers in that strategy were those companies tied to credit markets: mortgage REITs and business development companies (those that make loans to mid-sized companies).  These companies pay the highest dividends in the strategy and generally are considered more stable.  However, accompanying this “crisis” was a concurrent freezing of credit markets, reminiscent of the 2008-9 financial crisis, which frankly made no real sense except that, once again, the world was convinced everything on the planet was going to default.  The result was a complete and indiscriminate selling of anything and everything that was involved in lending money.  As of this writing, that has already started to significantly reverse itself as an astounding amount of Federal Reserve liquidity has been thrown at the situation to back-stop the credit markets.  It appears to be working as intended. 

The other weak area was the energy sector, which is not surprising given the collapse in oil prices as Russia and Saudi Arabia decided to institute an oil price war in the midst of the whole COVID-19 mess!  The overall “shoot first and ask questions later” mentality that prevailed in 2008-9 was back in full force.  We believe these issues will sort themselves out and eventually recoup full value.

As we mentioned earlier, we have gained some insights that confirm our overall approach to investment and also have reinforced our convictions regarding which industries and sectors will benefit as the world recovers from this debacle.  We are more convinced than ever that taking a “business approach” to investment decisions based on well-researched narratives surrounding demographics, technology and business processes, is a superior approach to investing. 

We have spoken, at length, to all of our portfolio companies and have been extremely impressed with the way they are handling this difficult situation.  This is not particularly surprising to us given that our mantra is “investing in well-managed companies in front of fertile fields for future growth”.  We have been privileged to witness the “well-managed” part in spades in recent weeks.   What is remarkable is that virtually every one of the companies in which we are positioned is still positioned in front of those fertile fields in spite of the massive shock the world has been hit with these past few weeks.

Areas like internet/network infrastructure (even more critical to business operations today than ever, as well as to our daily lives), business collaboration software, enterprise intelligence software, network security, 5G mobile edge clouds (how important is your cell connection right now?), automated factories (business process efficiency is key in this environment), virtual/augmented reality platforms, platform drug discovery (very important to streamline this process in a health scare) are just a smattering of the verticals that stand to benefit from what the world is experiencing at present.  Essentially, we liked our positions before this mess.  We like them more now! 

Still Pushing Back

On March 23rd we posted a piece "It's Time For A Pushback".  In it, we argued that shutting down the economy, and thereby creating severe economic hardship, can cost lives as it tends to harm the most economically vulnerable most severely; those at the lowest levels of the socio-economic ladder.  We usually are pretty benign in our commentaries, and thus, don't get much outside commentary back at us.  With that piece however, we had some detractors who thought we were crazy.

We want to emphasize that we fully support efforts to use common sense at controlling the spread of the COVID-19 virus.  That should go without saying.  We also understand that policy-makers are in a difficult situation of being "damned if you do, damned if you don't."  Therefore, our point was simply meant to balance the conventional wisdom about the repercussions of closing the world economy in the battle against the virus.  Those who don't believe that economic hardship cost real lives are simply denying the facts of history.

Since that time we have come across other voices who have echoed similar sentiments, here also.  One who we respect greatly for his insights on the economy and who we have been monitoring for over 25 years is Brian Wesbury of First Trust Advisors.  In his piece published today "Do the Least Harm", it would appear he has similar views to ours with respect to the economic impacts of shutting down the economy.  We appreciate Brian's commentary, as always.

Lastly, we have been in constant contact with our companies in the last few weeks, and while their stock prices have by no means been immune to the downturn, we are extremely impressed with the capable management teams that run our companies and are very confident that they will come out of this stronger than ever.  And in some cases, they will strangely benefit from this debacle.  Investing in "well-run companies in front of fertile field of future growth" has worked very well in the past and we believe will continue to work into the future.  Stay tuned.


Disclosures: Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Taylor Frigon Capital Management LLC (“Taylor Frigon”), or any non-investment related content, made reference to directly or indirectly in this blog will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this blog serves as the receipt of, or as a substitute for, personalized investment advice from Taylor Frigon. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. Taylor Frigon is neither a law firm nor a certified public accounting firm and no portion of the blog content should be construed as legal or accounting advice. A copy of the Taylor Frigon’s current written disclosure Brochure discussing our advisory services and fees is available upon request. If you are a Taylor Frigon client, please remember to contact Taylor Frigon, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services.

Don't own Zoom? Here's the next best bet: fund manager

Reuters, Posted April 3, 2020

Buy stocks of software companies that boost business efficiency such as AudioCodes, whose technology helps power Zoom and Skype, says growth fund manager Gerry Frigon of Taylor Frigon Capital Management. CLICK HERE for interview

Disclosures: Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Taylor Frigon Capital Management LLC (“Taylor Frigon”), or any non-investment related content, made reference to directly or indirectly in this blog will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this blog serves as the receipt of, or as a substitute for, personalized investment advice from Taylor Frigon. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. Taylor Frigon is neither a law firm nor a certified public accounting firm and no portion of the blog content should be construed as legal or accounting advice. A copy of the Taylor Frigon’s current written disclosure Brochure discussing our advisory services and fees is available upon request. If you are a Taylor Frigon client, please remember to contact Taylor Frigon, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services.

QUICK TAKE: ETFs Exacerbate Market Volatility

Trader's Magazine posted THIS article yesterday, April 1, 2020 by John D'Antona Jr.

Stock gyrations might not be the only thing pushing equity prices around.

ETFs – exchange-traded funds – which are baskets of individual stocks that are traded are tossing prices around and exacerbating volatility like a ship on the water during a hurricane.

In a brief conversation with Traders Magazine, Gerry Frigon, President and Chief Investment Officer at Taylor Frigon Capital Management said that ETFs are contributing to market volatility.

“If anyone really enjoys the kind of wild swings in individual stocks that make no fundamental sense, then they should just keep proliferating the “derivative” phenomenon of passive vehicles like ETFs and the algorithmic trading (algos) that are creating and profiting from such activity,”Frigon began. “All of those who say “I just use index funds” have no idea what they are investing in from a business standpoint. They are essentially allowing black-box models to deploy their investment dollars which are at the center of the problem with the market mechanism and these investors are actually contributing to the crazy volatility we are seeing, and have been seeing for some time now.”

Say it isn’t so, Gerry.

Yep, it is. Frigon pointed out that it was one thing when so-called “indexing” was a tiny fraction of the market, but now that almost 35% of invested funds are indexed, it’s an entirely different situation. When one couples that massive increase with the regulations spanning the past twenty years that essentially made it unprofitable for brokerage firms to make markets in OTC stocks (those are the small/mid-sized companies), and you have an illiquid market, subject to the whims of the computers.

And thus the wild daily or intra-daily price movements in ETF prices or their underlyings. As of this writing (April 1, 10:35 am EST) the DJIA was down 575 points at 21,341, just one hour after the open that saw the market down close to 1,000 points.

“After 35 years of watching our industry abdicate responsibility for making real investment decisions and come up with “products” that have nothing to do with financing real businesses, frankly, we have no problem saying what we see going on,’ he said. The same cannot be said for ETF issuers and their sponsors, he added.

Disclosures: Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Taylor Frigon Capital Management LLC (“Taylor Frigon”), or any non-investment related content, made reference to directly or indirectly in this blog will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this blog serves as the receipt of, or as a substitute for, personalized investment advice from Taylor Frigon. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. Taylor Frigon is neither a law firm nor a certified public accounting firm and no portion of the blog content should be construed as legal or accounting advice. A copy of the Taylor Frigon’s current written disclosure Brochure discussing our advisory services and fees is available upon request. If you are a Taylor Frigon client, please remember to contact Taylor Frigon, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services.