Are exchange-traded funds the investment tail that wags the market dog?

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ETFs mostly are passive (unmanaged) products that can be bought and sold in real time like stocks and that track any of the hundreds of broad and narrowly focused market benchmarks. How narrowly focused? One ETF holds companies thought to benefit from the so-called obesity epidemic (ticker symbol: SLIM).  While some ETFs have scant turnover within their holdings, others regularly alter the fund’s composition.

The combination of low cost and convenience underwrote an explosion in ETF assets, which now account for more than one-third of the U.S. equity market’s value. But the 14-fold increase in the number of ETFs since 2003 has raised concerns that billions of dollars of stock changing hands with the single click of a computer mouse might destabilize markets. And with the U.S. entering the final innings of the longest economic expansion in history, that could be especially problematic.

"ETFs mostly are passive (unmanaged) products that can be bought and sold in real time like stocks and that track any of the hundreds of broad and narrowly focused market benchmarks."

working paper by Itzhak Ben-David, Francesco Franzoni and Rahib Moussawi found that “stocks that are held within [ETFs] experience substantially higher intraday and daily volatility than stocks without substantial ETF holdings. … A one-standard-deviation increase in ETF ownership raises daily volatility and turnover by 16 percent.” Another study by Eric Belasco, Michael Finke and David Nanigian determined that flows into passive investments can distort valuations because of the artificial demand (or loss thereof) created by investors going in or out.

For investors and clubs doing their own research, the ETF explosion could have an upside. As more dollars are passively managed, the number of analysts should decline, causing stock prices to less accurately reflect all the known information. That, in turn, could create opportunities for investors willing to do the fundamental legwork. According to a 2017 whitepaper by Epoch Investment Partners, “A focus on company fundamentals, especially free cash flow, combined with a long-term time horizon can mitigate distortions being introduced by passive investing.”

The valuation question is one that investors need to examine closely. With regard to near-term volatility, the answer should remain the same as it’s always been: Ignore the daily ups and downs and stay laser-focused on the company’s long-term fundamentals.  Regardless of ETF-related questions, those fundamental numbers usually provide all the answers you need.

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