After two weeks of market turbulence, some observers are pointing the finger at exchange-traded funds (ETFs) as a key cause of market volatility. Is this justified? ETFs are certainly increasingly important. By value, they represented nearly 40% of the trading undertaken on the New York stock exchange on 8 August, a day when the Dow Jones industrial average recorded a near-5% fall. More and more investors seem to be using ETFs, rather than individual stocks, as a convenient way to express a view (ie, go long or short) on the market as a whole. In Europe, they aren’t quite as popular – on the London Stock Exchange, they represent just under 10% of overall share trading. Bid-offer spreads for ETFs in Europe are also higher than in the US, making it more expensive to trade.
But are ETFs actually causing sharp market moves? There’s some evidence that one type of fund has been responsible for swings just before the market close, especially in America. Leveraged ETFs, which are more popular stateside, need to have their portfolios rebalanced daily. The resulting buying or selling pressure can exacerbate end-of-day moves.
Another potential cause of instability is not unique to ETFs, but relates to the growing popularity of index-based investing. As more and more investors trade an index as a whole, rather than looking at the value of the individual constituents, those constituents’ prices increasingly move in tandem, with little regard to their individual merits. This, in turn, means that when share prices fall, the decline in a stock index’s value may well be greater than for a portfolio of randomly chosen shares.
For investors in index products, including ETFs, this perhaps means they should choose a less-widely followed benchmark, or one put together using different rules. Or when markets do sell off, as they have recently, a policy of putting low-ball bids in to buy popular ETFs may be rewarded. Finally, those pointing the finger at ETFs for making markets unstable may be better off worrying about the impact of overtrading. While there’s little evidence that markets’ fundamental volatility is much different to a hundred years ago, there’s plenty to show that people are trading too much. Average share holding periods used to be years: now they’re months, weeks or days. Your broker may thank you for excess trading, but your wealth will suffer. So choose your funds with care – and then leave them be.
• Paul Amery edits
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