The Flinchum File
Thoughtful Economic Analysis and Existential Opinions

Inside Baseball

10/12/2019

I like Exchange-Traded-Funds (ETFs).  (In fact, I’ve attended the “Inside ETFs” conference in Florida many times.)  Unlike mutual funds, which only trade at closing, you can trade ETFs anytime the market is open.  There are no tax bombs, like in some mutual funds.  With ETFs, you can make more targeted bets.  For example, I believe cyber-security is a growing sector and bought an ETF (HACK)  for just that sector.

While mutual funds have been around for many years, ETFs are relatively new to the investment scene.  The first was in 1993 with SPY that tracked the S&P 500 index.  If the S&P went up 1.2%, then SPY went up 1.2%, for example.  So, you didn’t have to bet on any company.  You could bet on the market as a whole.  Because ETFs were relatively new, the SEC scrutinized each new one very closely.  That just changed, effective in January, and we can expect many more ETFs to be issued in the near future.

Five years ago, there were over 1,500 ETFs.  Today, there are well over 3,000 different ETFs, with a market value approaching $4 TRILLION, and I expect that number to grow rapidly.

So what, you ask?  More ETFs just give investors more opportunities to make targeted investments, which is true.  But, I worry about so many thinly-traded ETFs in the event of a market collapse.  ETFs may not be the cause of the collapse but could easily make any collapse much worse.

Say you’re a portfolio manager for a mutual fund.  Since your shares are not redeemable until 4PM, you can watch the number of SELL orders build up during the day, waiting for the 4PM redemption.  If the number of SELL orders is getting high, you can sell enough stock to have sufficient cash on hand for that redemption.  In other words, you as an investor are almost assured of your ability to sell your mutual funds shares and get your cash.

Now, say you’re a portfolio manager for an ETF.  You only buy and sell company shares to stay consistent with your index, like the S&P 500.  You don’t know and don’t care how many SELL orders are out there for your ETF, as they are sold immediately in the marketplace . . . or should be?  An ETF share is not redeemed by the issuer, like a mutual funds share is redeemed.

As more ETFs are issued, they usually become more and more focused, slicing the market into thinner and thinner slices.  We can create an ETF for buggy-whip manufacturers, if you like.  Because few people have an interest in buggy-whip manufacturers, it will be thinly-traded, meaning there are few buyers and few sellers.  Now, what happens when the market is collapsing, and you want to sell your buggy-whip ETF, but nobody wants to buy it from you.  You cannot redeem it like a mutual fund share.

An old Wall Street expression is that “if you can’t sell what you want, sell what you can.”  That means sellers of buggy-whip ETFs must sell an unrelated investment to raise cash for a margin call or whatever, with this spillover effect magnifying the sell-off or increasing the volatility of the stock market.

I’m sorry the SEC is making is easier for new ETFs to be issued.  It may be good for the investors, but it is bad for the stock market.

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