ETFs, like Mutual Funds and Index Funds, are often praised for their ability to offer exposure to ‘risky’ equities while offering portfolio protection and reducing single stock exposure issues.
The basic idea is that instead of trying to ‘cherry-pick’ a specific winner or loser in a particular industry or sector, you can just buy a sector-based exchange traded fund and reduce your risk that you chose the wrong company to be the dominant player in that industry. Furthermore, as long as the industry itself performs well, your industry-focused ETF should follow suit, and your investment will benefit.
As the demand for ETFs increases, the vast array of offerings has also been increasing. As an investor, you are no longer constrained to just buying industry or sector-focused funds. You can now buy funds that focus on pretty much any correlating data point imaginable. Those are the ones that have strict investment guidelines, unlike some ETFs that are actively managed and give the fund managers complete control and leeway to invest wherever and however they want.
Currently, there are over 2,500 actively traded Exchange Traded Funds in the US alone. There were 32 new ETFs offered to investors in May 2021 alone. Let’s think about that for a moment. Outside of the OTC or Over the counter equities available to investors with about 11,500 stocks in 2020, roughly around 6,000 companies’ investors can buy and sell stock in which are traded on the major US exchanges, the NYSE and the NASDAQ. Yes, that is correct, 6,000 US stocks and nearly half that in US ETFs.
Now there are obviously other investments that make up ETFs other than just equities, such as bond ETFs, currency ETFs, and even foreign equity ETFs. However, a simple ETFs screen shows that 1,797 of them are equities-based ETFs, and of those, 1,045 are made up of just US-based companies.
So, of the roughly 6,000 US equities investors have to invest in, more than 1,000 US equity-based ETFs are investing in those 6,000 companies. When you think about it that way, it’s not hard to wonder how much overlap we have with different ETFs, even ones that claim to be investing in different areas or sectors of the economy.
Furthermore, market participants have sounded the horns for a few years now that as ETFs grow in popularity, so will and or have their influence on the markets. In the past, mutual funds were king, but that is slowly changing as more investors lean towards ETFs because of their simplicity, ease of access, and liquidity. With Mutual funds, you typically have to invest a certain amount to open the account. You also need an advisor or someone to help you buy the fund since most are closed to outside investors. Furthermore, mutual funds are slow to buy into and pull your money out of, while ETFs can be traded just like stocks, and investors can be in and out of them in seconds, real-time, not close of business.
Some market participants claim this has given the market more liquidity. In contrast, others fear that big swings in and out of the markets by investors trying to ‘time’ the market or day trade can have ripple effects across the whole industry. Just keeping an eye on ETF cash flow from week to week can prove that some of these fears are true, and those big redemptions can put increased selling pressure on the markets, and big inflows can cause stocks to rally for no apparent reason.
The fact of the matter is, while ETFs are reducing single stock risk as they were intended to do, they may be causing other unforeseen risks in terms of market volatility. While the big market moves in 2020 were largely Covid-19 related, investors can’t ignore the fact that over the last few years, we have seen more and more days when the markets move 1% or more in either direction. These sorts of moves could in large part be due to the role ETFs now have in the market and the ability that they offer investors to move in and out of the markets with large quantities of money in seconds, not days like in the past when mutual funds ruled the investing world.
Disclosure: This contributor did not hold a position in any investment mentioned above at the time this blog post was published. This article is the opinion of the contributor themselves. The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. This contributor is not receiving compensation (other than from INO.com) for their opinion.