ETF Fear Mongering Myths

ETFs have existed for more than 26 years. That’s longer than a third of the U.S. population has been alive.

Through the dot-com crash, the Global Financial Crisis, taper tantrums—and, more recently, a 20% market swoon in the back half of last year—ETFs have aged well. But somehow, ETF fear mongering is still alive and well. Some recent examples:

“ETFs have been hugely popular, and now roughly half of all stock is owned by ETF buyers. That would imply that if the markets start to decline, half the owners in the market could be selling the entire market when they hit the “sell” button.” —Business Insider, In a liquidity crisis, here’s what to look for

“In a Down Market, ETFs Could Make Things Even Worse” —The Wall Street Journal

“ETFs Threaten to ‘Amplify’ Systemic Risk When Liquidity Dries Up” – Bloomberg

Here’s a Barron’s Q&A with an advisor who oversees $3.6 billion!

What? Where is this coming from? I’ll get to that in a minute, but first, let’s tackle the false narratives, which is surprisingly easy to do with a few pretty charts.

Half of all stock is owned by ETF buyers? Nope.

Maybe they meant bonds? Nope.

Source: A Wealth of Common Sense, 2/27/2019

But in a down market, ETFs could make things worse, right? Well, only if you think something responsible for less than 5% of individual stock trading can exacerbate the situation.

Without getting into the mechanics of ETFs (which you can do here), the vast majority of ETF trading is investors simply swapping shares with each other in the secondary market (think buying or selling ETFs through their eTrade account).

While ETFs account for roughly a quarter of all daily trading volume on stock exchanges, less than 5% of individual stock trading is the result of ETF inflows or outflows (i.e., the primary market).

But what if everybody wants to sell their ETFs at the same time?

Well, let’s think about this. Is it only ETF investors who will want to sell their shares? Or is it investors who want to sell shares? Why would only ETF investors want to sell? Is there something unique to mutual fund investors or individual stock owners that makes them any different?

Even if every ETF investor wanted to sell (which would never happen), remember that ETFs only own approximately 6% of the stock market and 1% of the bond market.

(OK, here comes the ETF fear monger trump card …)

But, what about flash crashes? Remember those? Yes. Read this and this. Here’s the cliff notes version. I call this the McDonald’s chart, “Billions and Billions Served.”

The bottom line is that ETF prices are only as good as the prices on underlying securities. If those underlying securities aren’t pricing properly, neither will the ETF—or any other investment relying on those individual security prices.

What’s The Beef?

So why the attacks on ETFs? Simple. They’re disruptive. They’re costing the old guard real money. While still a small part of the financial markets overall, ETFs recently surpassed $4 trillion in assets. They’re taking market share from mutual funds. Investors are voting with their hard-earned money.

When something is disruptive, people attack—typically out of fear. Bloomberg’s Eric Balchunas keeps a list of the top 10 attacks on ETF. These are real things people have said.

Unsurprisingly, many of the attacks come from underperforming mutual fund managers. Ironically, mutual funds have suffered their own liquidity issues recently. Even more ironically, mutual funds tend to own the same underlying securities as ETFs. From Michael Batnik:

Source: The Irrelevant Investor, 6/30/2018

I want to emphasize Michael’s last point: People sell stocks during bear markets. The wrapper doesn’t matter. As The Wall Street Journal’s Jason Zweig explained:

“If index funds cause market bubbles, they’re not nearly as good at it as human beings are. Why should we be more afraid of index funds causing a bubble today than anybody was of active investors causing one in 1999 or 1972 or 1929?”

Of course, ETFs weren’t around in 1929 or 1972, and were barely getting going in 1999. If investors want to sell stocks or bonds or bitcoin or Pokemon cards, they’re going to sell.

The questions to ask when encountering ETF scare pieces are these: What will mutual funds do? At what prices will mutual fund managers or investors transact on their individual stock/bond holdings in a market downturn? Will they be different prices than ETFs? Why?

ETFs are simply vehicles to access markets. These vehicles are driven by humans. Humans, not ETFs, drive markets. Or as Eric Balchunas more colorfully stated:

“This is why blaming a stock bubble on ETFs is like blaming MP3s for Nickelback or One Direction.”

Follow Nate Geraci on Twitter @nategeraci