ETFs and Volatility
January 8th, 2018
The most notable trend in 2017 has been the widening disparity between economic gains and social and political unrest. Despite deep political uncertainty around the globe and in the world’s largest economy, the VIX, an expected measure of U.S. market volatility has remained historically low. Accompanying this decrease in volatility has been the prolific rise of Exchange Traded Funds (ETFs) which now control over $3.5 trillion in the U.S. alone (Figure 1). The relationship between these two factors has been a matter of continuous debate in the financial community. Some experts believe the rise of ETFs have artificially decreased volatility while others hypothesize ETFs instead act as a source of market unrest. The reality is a combination of both views. ETFs don’t have a significant effect on volatility or pricing today. However, if the cash-flow trend out of active to passive management continues, ETFs will pose a unique threat to market stability on a global level because of their unique structure of non-selective abandonment.
The past year was a boon to many developed and some emerging economies. Global trade rebounded, growing faster than global GDP. Commodities recovered in response to increased demand. M&A activity has surged due to an expectation of rising future interest rates and huge stores of cash have flowed into alternative investments seeking higher returns. More widely covered has been the record-breaking year for stock markets around the globe. The S&P 500 posted 12 straight months of gains, the first time this has occurred in a calendar year. Additionally, for the first time in nearly a decade, all 45 members of the OECD community have experienced positive growth. On the flipside, global political unrest greatly increased, humanitarian crises continue to plague large regions of the world, natural disasters cost billions in damage and the future of one of the world’s largest markets, the European Union, remains uncertain. Throughout all of this, key economic theories have struggled to explain new trends in a post-QE environment. In the U.S. specifically, the Phillips Curve, describing the inverse relationship between unemployment and inflation rates broke down for the year. In 2017, inflation remained stagnant in the face of low unemployment although this trend may reverse in 2018. These negative factors are typically associated with investor unease and therefore increased volatility. However, as shown again in Figure 1, this has not been the case.
In response to these discrepancies, many market analysts have sought answers in the recent rise of ETFs. As shown in Figure 2, in 2016 ETFs composed a cumulative 30% of all U.S. trading volume by dollar. This number has likely grown substantively in the past year as billions more have poured into passive management, totaling over $3.5 trillion in AUM by ETFs as of December 2017. Some analysts point to high AUM and trading values as indicators that ETFs may have the financial clout to significantly drive markets. Given this fact, analysts may hypothesize that frequent trading of ETFs result in increased volatility of the underlying securities in their portfolios. They hypothesize that extraneous factors have helped push volatility to low levels but ETF trading is responsible for current volatility spikes. Recent studies by Credit Suisse and BlackRock show that increased ETF trading does correlate with spikes in volatility as measured by the VIX. However, although ETFs may eventually pose a volatility threat, in the current market environment, associated volatility spikes with ETF trading are a matter of correlation, not causation. The reason is that ETFs are often a means of “tactical allocation” and “price discovery.” Tactical allocation simply means that ETFs are used as tools to hedge and short other trades and financial transactions. These hedges and shorts may be exercised during the revelation of macroeconomic or financial concerns. These concerns also generally result in an increase in overall market volatility. Price discovery on the other hand, describes an ETF’s tendency to occasionally stray in value from the compiled price of its underlying securities. This is because ETFs may trade on different exchanges than those used by its underlying assets. The result is that an ETF may trade in New York while the Chinese securities it is comprised of are dormant overseas. However, arbitrageurs will soon take advantage of these price differentials when markets open back up. In fact, there is evidence to show that ETFs may instead currently act as a moderating force in market volatility. During the 2013 Taper Tantrum, in which high-yield bonds sold off sharply, ETFs provided liquidity and transparency, thus acting as a buffer on downward-price pressures.
Despite these current market conditions, if ETFs continue to gain more control over the corporate equity market, they may push past a significant level to a point where they pose a unique threat to global market stability. Owing to their unique structures, crises sparked by, or containing, significant ETF involvement will run a high risk of contagion. The reason to keep a wary eye is the same reason ETFs prove to be such an effective investment vehicle. They are a low-cost way to own a large variety of different assets. Normally, tracking the S&P 500 would be incredibly difficult for most retail and many mid-sized investors. The fees would be high and constant attention would have to be spent in order to maintain proper weightings based on market cap or a host of other factors. ETFs have proved the solution. It no longer takes a well thought- through trading plan to buy into or sell out of 500 or more securities. Instead, an investor can gain, lose or shift exposure easily over an exchange. The downside to this ease of investing is what can be termed “non-selective abandonment.” This refers to an investor’s inability to hold or sell specific stocks within an ETF. When an investor sells SPY, they sell all of its underlying securities. At the moment, this isn’t a problem. When ETFs are bought and sold their underlying securities remain stationary in a trust account managed by what is known as an authorized participant. The securities themselves are being traded in a more indirect matter through an ETF, despite being “sold”. This may have some buffering effect on dramatic ETF movements as ETFs are commonly in a quick-fire game of catch-up. ETF prices can lag significantly behind the cumulative price of their securities on the open market. If securities are being traded individually more than they are through ETFs this isn’t a problem. Liquidity is flushed. However, if more shares of a company stock are owned in pooled ETFs than individually, a problem arises. Individual company share prices are now tightly bound to market moods and movements despite their own fundamentals. Some might argue this is already somewhat the case, but it would be much more significant in an ETF-dominated system.
In this ETF-dominated system, major ETFs such as those tracking the S&P 500 (SPY, IVV, VOO) would have an unprecedented say in the determination of prices for all their underlying securities. In a potential scenario, a negative economic event might prompt investors to dump their S&P 500 ETFs. In this system, such an action would drive down the value of all included shares indiscriminately. A falling market driven by these initial sell-offs would prompt more selling of major ETFs. Companies with strong fundamentals to back up their market valuations would be caught in the fall and liquidity for individual buying/selling of shares would be dry. What’s worse, as shown in Figure 3 below, over 70% of the top ten ETFs by AUM currently have direct exposure to U.S. equity markets. Those with exposure to both U.S. and foreign markets such as the QQQ PowerShares would be responsible for a dramatic contagion effect. Non-selective abandonment would drag down the value of their core U.S. holdings, thus dragging down the value of the ETF. Soon their core foreign holdings would feel the downward strain as investors fled due to the dropping ETF price.
Two additional factors could further exacerbate the situation. The first is the recent emergence of ETFs of ETFs. These unique financial instruments enable an investor to engage in multiple different trading strategies under a single ticker traded on an exchange. They may consist of thousands of individual securities around the globe. In an ETF-dominated system, ETFs of ETFs would act to further dry up liquidity, resulting in sharp price declines in the case of a crisis. Additionally, ETFs steal some security away from traditional safe haven assets such as gold or other commodities. ETFs fully cover commodities, with many consisting of both commodities and equities. Again, a drop in the price of equities could prompt sell-offs of those ETFs with exposure to those equity markets. If there is overlap with ETFs consisting of commodity holdings, then the security of these typically safer markets would be threatened.
In the case of an ETF driven crisis, or any crisis, there are two seldom discussed considerations that investors and traders should keep in mind. The first is that spotting a potential crisis is not the most difficult task. If an investor sees red, they need to first decide their approach if their negative forecasts are correct. Are they looking for security or profit? In the case of an ETF-dominated system, security from a crisis most likely comes in the form of cash. As previously mentioned, commodities including gold may be caught in the fray. On the other hand, an investor seeking to profit will look for opportunities to catch the downward trend. This may include placing bets on volatility or shorting wide markets. Delving further into preparatory steps, it must be noted that timing is everything in the markets. A commonly cited phrase in finance is that “the markets can be irrational longer than you can be liquid.” A crisis with no catalyst is just business as usual. Shorting a market when it is going up, even if irrationally so, is going to eat into capital up until a margin call. The second, most important, consideration is proper risk management. Regardless of whether an investor seeks profit or security, exposure must be managed. This would be particularly difficult in an ETF-dominated system as many more markets would be interwoven. Due diligence and honest assessment are the backbones of long-term wealth management.
Although the current financial system is safe from the potential effects of an ETF-dominated system, it is necessary to keep a watchful eye on further developments. The SEC and CFTC should continue to update their regulatory frameworks in response to continued ETF growth. At the same time, investors and traders should carefully monitor ETF trading volume and liquidity levels. At this point in time, ETFs are safe financial instruments. Their rise may be additionally checked as capital tends to flow towards more active management in the case of a crisis or low performing markets. If the current markets turn bearish, capital may flow back towards active management. One trend that is clear however, is that ETFs are here to stay.