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.