The Flinchum File
Thoughtful Economic Analysis and Existential Opinions

Just Another Useful Tool

01/31/2020

While I have been a long-time advocate for exchange-traded-funds (ETFs), I never thought they could bake bread nor cure the common cold.  Yesterday, I attended a lecture entitled “Combating Fake News:  Why Exchange-Traded-Funds Won’t Cause the Next Market Sell-off.”  I saw a great many graphs documenting that ETFs continue to grow during both bear and bull markets.  Frankly, I didn’t realize that ETFs were under such criticism that they needed such a full-throated defense.

Anyway, I agree that ETFs are not “weapons-of-mass-financial-destruction” nor “rat poison-squared.”  They are just useful tools, like a hammer or a screwdriver.

However, two problems were not discussed.  First, ETFs have significant “survivorship bias.”  Unless they raise at least $25 million in assets-under-management (AUM) rather quickly, they cannot be profitable and simply disappear, returning whatever money they can.  ETFs disappear more frequently than mutual funds.

More importantly, stocks or ETFs can sell at a premium or a discount to their book value.  If you pay more than book-value-per-share, you have paid a premium.  That’s great for sellers.  If you pay less than book-value-per-share, you have gotten a discount.  That’s bad for sellers.

This becomes important during a market meltdown, when sellers “rush the exits.”  Buyers seek the relative safety of bigger, more heavily-traded securities than smaller, thinly-traded ones.  That means smaller, thinly-traded ETFs sell at bigger discounts, amplifying the downward pressure.  (Fortunately, this applies to a very small percentage of ETFs.)

For some reason, the speakers overlooked these two problems?

 

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