Liquid Strategies Insights & Commentary

ETF’s – Part of the Solution or Part of the Problem?

Author: Justin Boller

 

With all areas of the market in turmoil, there has been extra scrutiny placed on ETFs and their role in the financial markets. ETFs have seen exponential growth over the past decade, as investors have gravitated towards typically lower costs, tax advantages, and intra-day trading capabilities. With this meteoric rise, investors who are not familiar with this structure can get spooked and fear a bubble building in the market.

That fear is driven by a misinterpretation of an ETF as a security rather than a vehicle. Bubbles form when a certain segment of the market or becomes oversubscribed, pushing prices substantially above fair value. This occurred in the bubble created in the late 90's when technology companies were attracting investors without demonstrating the ability to turn a profit. The same is true in the financial crisis as investors were loading up on sub-prime mortgages without caution to the inherent risks. ETFs are vehicles that represent a broad segment of asset classes and sub-asset classes. Some are broadly diversified while others are more narrowly focused on a specific segment of the market. The market segments remain subject to a bubble, and the vehicles used to access those segments will demonstrate the whipsaws of the bubble potentially popping. However, it does not work in reverse. Meaning the vehicle (ETFs in this case) do not cause the bubble.

Nearly all major financial crises are marked by a liquidity squeeze as investors rush for the door. Our current crisis is no different. One of the first sources of liquidity for most firms trying to make payroll or investors who don't want to panic sell their equities is their fixed income holdings. As the supply/demand forces shift, there is a natural repricing of fixed income securities. Unlike equities, individual bonds do not necessarily trade on a daily basis. Therefore, there can be a dislocation between the true current price last printed price. Skeptics have attributed the dislocation in prices to being caused by ETF's when in fact it is simply a selloff in the asset class and not the vehicle.  That said, ETFs do command a lot of assets, so when there is an exit from fixed income, they will be party (not the cause) to that rush. This is why the Federal Reserve, in their most recent announcement, has included investment grade bond ETFs as one of the securities they will support in their quantitative easing efforts. It's not a reflection on the vehicle, but a recognition of the vehicle as a way to most efficiently support the ETF market. Being buyers of the ETF creates a simple transaction between the sellers of the security and the Fed and alleviates the need for the ETF manager to sell the underlying securities in the open market.

During the most recent bout of fixed income market volatility, ETFs have proven to be a source of liquidity rather than a cause of illiquidity. ETF's were invented after the 1987 crash for this exact purpose and in each of the crises since have proven their value as both liquidity providers and price discoverers. We believe ETFs continue to be a value added solution for investors rather than a cause of the problem...particularly in times of crises.

 


 

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The assertions and statements in this blog post are based on the opinions of the author and Liquid Strategies. The examples cited in this paper are based on hypothetical situations and should only be considered as examples of potential trading strategies. They do not take into consideration the impact that certain economic or market factors have on the decision making process. Past performance is no indication of future results. Inherent in any investment is the potential for loss. 

Topics: Overlay, ETF

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