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
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