Are ETFs the cause of recent international market volatility?
iShares Australia's Tom Keenan debunks the myths about the causes of market volatility.
Financial market historians may well look back on the 1990s and even a large slice of the 2000s as something of a holiday from volatility.
Of course, volatility was not absent during that era, as the bursting of the internet bubble in 1999 and the sharp market setback on the heels of the terrible events of September 11, 2001 in New York make clear.
Still, it was a time aptly described as “the great moderation”. Economic and profit growth was upbeat and capital markets’ volatility was subdued by historic measures.
Volatility has picked up since the 2008 global financial crisis (GFC) and there is now a search for an explanation for its causes.
Some commentators have sought to attribute this uptick in volatility to the rapid growth in use of exchange-traded funds (ETFs): low-cost index funds that trade on heavily regulated stock exchanges around the world.
There are a few problems with this view, however. It seems to display a lack of awareness of what’s been happening in capital markets and economies in recent years and a misunderstanding of the workings of ETFs.
Macro forces moving markets
Former British Prime Minister Harold Macmillan, when asked by a journalist what can most easily steer a government off course, answered “Events, dear boy. Events”.
Today we can just as credibly say that events, more specifically, macro events, are driving markets. This is not a revelation to market participants.
Simply put, the world is a riskier place post-GFC, with uncertainty overwhelmingly driven by global macro-economic factors.
Research points to the substantial increase in the volatility of macro-economic indicators: gross domestic product growth, inflation and money supply measures have all become markedly more volatile relative to a more stable environment pre-GFC.
Who would have imagined even five years ago that central banks like the US Federal Reserve would resort to extraordinary measures like quantitative easing, unkindly described in some quarters as “printing money”?
The world of today is one in which the resulting disagreement between forecasters of growth and inflation is quite pronounced and explains a statistically significant degree of volatility.
When macro-economic factors become unstable, the prices of financial assets (stocks, bonds, currencies and the like) do too.
Current research by BlackRock and other industry participants suggests that there is no statistically significant causal relationship between ETF growth and higher market volatility.
Knocking down one myth at a time
The “ETFs are the cause of volatility” camp’s argument seems to boil down to a belief that larger market swings are somehow the result of trades in the underlying stocks in an ETF. Available evidence seems to belie those claims.
There is a misconception that all ETF trades (or a high proportion) result in the same proportion of trading of the underlying stocks.
It is true that, given the open-ended nature of ETFs (which allows them to expand and contract based on demand, unlike a traditional stock), that trading in the underlying securities of the ETF ‘basket’ can and does occur.
But ETFs do not automatically amplify trading in underlying stocks, as they can also be sourced from existing inventory (held by market makers) or on the open market (thus overcoming the need to create or redeem ETF units).
In the US, it is currently estimated that on average only 15 per cent of ETF trades result in trading in the underlying stocks.
Even the most heavily traded ETFs generate create/redeem volumes generally averaging a very small percentage of the underlying dollar volume of the underlying securities.
Another theory is that arbitrage trading of ETFs causes higher turnover in the underlying assets.
But an ETF would need to be traded sufficiently inefficiently for an arbitrageur to benefit and want to move into the market. Our perspective is that ETFs rarely trade at levels that would encourage an arbitrageur to act.
Yet another proposition that gets knocked down is the notion that ETFs distort markets, particularly towards the end of the trading session.
In fact, the opposite holds true, with ETFs generally traded at the open of trade in response to overnight economic news rather than towards the end of the day when there is insufficient time for market makers to hedge or arbitrage their positions.
Indeed, market makers are more likely to be risk averse at the end of the session than at any other time.
ETFs have been identified as a cause of correlation. On this score, we do find some supporting evidence. There is a tendency for a rise in ETF trading to coincide with rising correlations.
However, our view is that attributing high stock market correlation to ETFs is an instance of confusing correlation with causation.
Rather than ETFs causing high correlation, it is higher correlation that has helped ETFs to grow in usage.
During periods of high macro uncertainty, stock prices are largely driven by macro factors. At such times, stock prices tend to be less differentiated, leading to higher correlations.
ETFs’ role in price discovery
It is difficult for ETF practitioners like me not to sound too evangelical about our subject. So rather than resisting temptation, I’ll give in to it by pinpointing yet another feature of ETFs.
They are a powerful tool in price discovery.
Price discovery refers to the idea that ETFs can offer access to securities that trade on markets that are not open (as in the case of international funds) or less transparent (for example, the fixed income over-the-counter market).
With recent market flare-ups being of the global variety, this has been an important characteristic. ETFs have allowed investors across the world to express views on a particular aspect of the market no matter where they reside – and whether underlying markets are open or not.
Volatility preceded existence of ETFs
Many of the arrows fired at ETFs may owe to the fact that the product segment is barley 20 years old globally (and only 10 years old in Australia).
Their newness can make them a source of curiosity as well as an occasional target of criticism.
Macro-economic forces, rather than ETFs or other financial instruments, are more likely to be the source of higher volatility. Investors are reacting to a rapidly changing world. They are being moved by events and news flow.
ETF growth has coincided with a shift to a more macro-oriented and uncertain economic environment and is the result of investors’ need for transparent and efficient tools to manage their portfolios in these challenging times.
We would argue that it is in volatile markets that the benefits of ETFs can become more apparent. During volatile times, investors have increasingly turned to ETFs as a way to express their views with precision and in a low-cost, efficient way.
A final thought: the levels of volatility currently being experienced are not historically unprecedented and have been observed long before ETFs ever came on the scene.
Tom Keenan is the director of iShares Australia.
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