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Do ETFs make the market more volatile?

The answer is not as cut-and-dried as you may think


Date: February 9, 2016


Exchange-traded funds have grown into an investment phenomenon, prized for their liquidity and low cost. They allow investors to cheaply and easily invest in a variety of securities close to home as well as in far-off markets.

Because ETF products and investing in ETFs have exploded as investors are increasingly attracted to the ability to dip in and out of a variety of investing strategies, some market watchers have raised concerns that ETFs cause or increase volatility.

The question being: Does the fact that the ETF is traded as a separate entity to the stocks it holds create opportunity for investors to capitalize on that in a way that increases volatility?

A research paper titled Do ETFs Increase Volatility? by Itzhak Ben-David, Francesco Franzoni and Rabih Moussawi suggested ETF ownership does increase stock volatility, but not necessarily as a result of flows in and out of ETFs. Rather, the greatest volatility seems to come from arbitrage trades between the ETF and the underlying stocks, as more investors use ETFs for speculative purposes.

In other words, volatility comes from savvy traders making money off the difference in pricing between the ETFs and the underlying securities. But the experts say that is rare.

But ETF proponents, who view the funds as a cheap way to invest in the underlying securities, say that the funds only mirror the volatility churning through the markets. For them, it’s like blaming the mirror for making you look fat.

Matt Tucker, head of fixed-income strategy for BlackRock Inc.’s iShares, the company’s ETF group of funds, looked at the issue and concluded that while ETFs allow investors unprecedented ability to put money into securities and jurisdictions that they couldn’t otherwise, fluctuations in ETF prices simply reflect prices of underlying securities. ETFs mirror reality rather than operating as some sort of distorting funhouse mirror, in other words.

“In my mind it is certainly correct,” said Yves Rebetez, managing director and editor of ETF Insight. “If I am looking at the volatility of the S&P/TSX 60 ETF [BlackRock’s XIU] the volatility that it experiences today, or it exposes me to today, is really a reflection of the volatility that you are seeing in the underlying components that comprise the ETF.”

Mr. Rebetez noted that the U.S. Securities and Exchange Commission has investigated what role if any ETFs play in market volatility and how to deal with their potential effects on the market. One issue he identified is the example of day traders who could buy and sell ETFs during periods of extreme volatility and potentially contribute to volatility.

“I’m not going to say that I don’t think that could be a consideration,” he said, but “those day traders, by and large, are really few and far between relative to all the assets that are held with ETFs.”

It may be that ETFs are fingered as volatility villains because they are relative newcomers to the investment scene, feature ultra-low costs and are popular. “If you supply a new vehicle, does that mean that people are going to be more speculative?” asks Tyler Mordy, president and chief investment officer of Forstrong Global, a Kelowna, B.C.-based investment firm which specializes in the use of ETF portfolios.

ETFs, in his mind, are inherently conservative investment vehicles, rather than potential weapons of mass disruption for trigger-happy traders. “The spirit of ETFs all along has been that it encourages diversification, it encourages a focus on cost and longer-term thinking.”

Mr. Mordy adds that the liquidity of ETFs can have a positive effect on valuing the underlying securities. He notes that the funds were stress tested during the 2008 financial crisis when the high-yield bond market had “seized up and there was really no bid and ask on a lot of the underlying [securities].” The ETFs that mirrored those stalled securities kept trading and “it provided better price discovery than the underlying.”

That doesn’t mean that ETFs should not be approached with caution, Mr. Rebetez said. “There are some rules that don’t necessarily apply to other securities, and one is you never trade in the first half hour or the last half hour, and you always use limit orders. And it holds for institutions as well as retail players.”

And he does have a concern about the potential volatility-inducing power of ETFs in sectors of the market with low liquidity, such as high-yield bonds or corporate bonds where it is harder to find a buyer for the underlying securities. “It is a potential risk and it is a potential price dislocation that I think regulators are concerned about.”

Mr. Rebetez added that regulators may be even more focused on the rising role of ETFs in a market where the future direction of interest rates is highly uncertain following a remarkable period marked by three decades of steadily falling rates. In other words, because interest rates may become more volatile, savvy traders may seek to take advantage of that by trading the ETFs.

In the end, looking beyond day-to-day volatility is particularly important for Canadian investors today, Mr. Mordy said. “The recent experience of Canadians is understanding that the big picture is everything.” For instance, he cites the commodity bear market and its impact on the Canadian dollar.

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