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.
