Could exchange-traded funds blow up and take the markets down with them?
A report released Nov. 8 argues that ETFs are "radically changing the markets," raising the prospect of a "panic-driven market meltdown."
ETFs are funds that hold all the securities in an index and themselves trade like a stock.
The report, produced by researchers at the Kauffman Foundation in Kansas City, Mo., which supports research on entrepreneurship, has its shortcomings -- and was met with howls of derision from ETF experts. "A whopper," said Dave Nadig of IndexUniverse; "riddled with untruths," said Tom Lydon of ETF Trends.
But the report's authors, Harold Bradley and Robert Litan, have considerable expertise of their own. Bradley, the foundation's chief investment officer, was formerly head trader and a senior portfolio manager at the American Century funds. He helped introduce the first stock-index futures contract in 1982 and was a pioneer of electronic trading. Litan, the head of research at the foundation, has worked at the prestigious Brookings Institution and is a widely respected economist.
Let's start with concentration. According to the report, a single ETF, the iShares Russell 200 Index Fund (IWM), is among the 10 largest holders of 1,737 stocks -- many of which also are held by other iShares ETFs.
Yet ETFs aren't traditional mutual funds. At an ETF, the manager's job isn't to make judgments on single stocks, but merely to keep the portfolio as close to its index as possible. And, in contrast to a mutual fund, "no one stock represents a large portion of the typical ETF," says Gus Sauter, the chief investment officer at Vanguard Group.
Overconcentration might even have been more worrisome in the pre-ETF era, when big mutual funds routinely stomped in and out of small stocks. "But what if you double the size of ETFs?" Bradley asks. "What if you double them again?" Because ETFs must buy the stocks in the indexes they track, regardless of price, it is legitimate to wonder whether values aren't getting out of whack as ETFs come to dominate the market.
And every investor should worry whether the instant liquidity that ETFs purport to offer should be taken for granted in thinly traded markets.
What about trading failures? The Kauffman report says increasing numbers of buy orders for ETF shares are failing to "settle," or going uncompleted. Fund sponsors don't agree.
"Based on what we've seen, ETFs settle much more efficiently than single stocks when you look at it as a proportion of total volume," says Leland Clemons, a director in the capital-markets group at iShares, the largest ETF sponsor.
At the very least, regulators should look into the Kauffman claim that ETF trades fail at 10 times the rate of individual stocks.
Continued: The risk of a systemic panic
