Are ETFs Driving Stocks Higher?

Two of the biggest stories in financial markets this year: exchange-traded funds gathering record-setting amounts of assets while the stock market relentlessly marches to new heights. This raises the question, are the two connected?

You might think they are, based on a flurry of headlines from earlier this week that insinuated ETFs were the driving force behind this year's stock market ascent. Those articles cited a Goldman Sachs research report that said ETFs now own 6% of the U.S. stock market, the highest-ever ownership percentage.

But Goldman analysts never came out and explicitly said ETFs were driving the market higher, just that they were an increasingly large buyer of equities.  

Into ETFs, Out Of Mutual Funds

After all, the growth of ETFs over the past few decades has taken place irrespective of what's happened with the stock market. ETFs have gained assets through up and down markets alike, so why would they suddenly be such a significant driver for stock prices?

They're not, according to Todd Rosenbluth, director of ETF and mutual fund research at CFRA, because the money going into U.S. equity ETFs is largely replacing money coming out of active equity mutual funds.

That's one of the reason ETFs shouldn't be credited for the market's rise, says Rosenbluth. Additionally, "more than half of the inflows this year are for international equity ETFs, which would not be impacting U.S. stocks," he explained.

Meanwhile, if the inflows into U.S. equity ETFs were notably impacting U.S. stocks, Rosenbluth added that "then there would be a tighter range in performance of sectors, yet we have energy and telecom significantly lagging technology and health care."

The Relentless Bid Effect

Even if ETFs aren't pushing stocks up, they could still be impacting the market in other ways. Josh Brown, CEO of Ritholtz Wealth Management, published a viral blog piece in 2014 that explained how the big Wall Street wire houses' push toward fee-based money management and away from transactional commission-based management has "greatly affected the behavior of the stock market." 

The result is less churning and more long-term investments in things like passive ETFs. Brown said that the new paradigm means there was "a relentless bid" under the market "as the torrent of assets comes flowing in every day," leading to "shorter and smaller corrections."

That sure sounds like the market of today, with billions pouring into ETFs daily, and the lowest volatility for equities in decades.  

ETFs Punching Above Their Weight

All that said, it's still hard to ignore the sheer magnitude of the inflows into ETFs, particularly this year. Through the end of May, flows into exchange-traded funds have averaged $2 billion per trading day, almost double last year's rate (though only about a third of that has gone into U.S. equity ETFs).

That may not sound like much compared to the $295 billion worth of securities traded on U.S. equities markets on an average day (according to Bats Global Markets), but stocks are priced on the margin, so a few billion dollars here or there could potentially move the needle.

Ilya Feygin, managing director and senior strategist at WallachBeth Capital, says the evidence suggests ETFs have been a big driver for the market this year. He told CNBC that "the market has often made strong gains in weeks of strong inflows even in the face of bearish macro news, and it has paused when there is not much inflow, or the inflow went to international ETFs instead of U.S."

Another data point that indicates ETFs may be punching above their weight in the market is the fact that they now account for nearly a third of all U.S. equity market trading volume, according to Credit Suisse.

Vehicle For Buying Stocks

Perhaps the truth is somewhere in the middle. ETFs are helping fuel the market's run, but that money would be coming into stocks regardless, whether in the form of individual stocks, mutual funds or hedge funds. ETFs are simply investors' preferred vehicle for getting market exposure today.

That's the explanation that resonates with Eric Balchunas, senior ETF analyst for Bloomberg.

"They're definitely having an impact, in that people are putting money into ETFs, and then that will spur creations, and the creations mean stocks get bought," he said. "However, nobody is buying an equity ETF unless they want stocks." 

"A lot of the new money that would have been investing in the market anyway just happens to be using ETFs to do it. This money would have been going into active equity mutual funds or it would have been buying stocks directly," added Balchunas.

The new money would have been buying the same securities anyway, it's just now inclined to do it in a more tax-efficient, flexible and cheaper wrapper, explains Balchunas: "ETF flows aren't the reason stocks are going up; it's because people want equities." 

Contact Sumit Roy at [email protected].