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Busting the five most common myths about ETFs

With active managers gearing up for their annual “this’ll be our year” outputs, we thought it time to address the persistent speculation about the way ETFs influence markets and performance. Our latest ETF Research paper tackles the five most frequent concerns: 

1. ETFs are getting too big

In fact, the ETF footprint is still fairly small. In the largest market, the US, ETFs represent 7.6% of the equity market; in Europe it is even less, at 4.4%. As such, they can’t exert any real influence on the asset markets in which they operate.  

Could this change? There’s little evidence of “creep” so far. Between 2000 and 2016, ETFs’ aggregate ownership share of three popular US equity indices— the S&P 500, the Russell 1000 and the Russell 2000— only grew by around 0.4% per year. 

In the secondary market, ETFs based on the Euro STOXX 50 represent 2% of the cumulative average daily volume traded. Within bonds, the numbers are similarly inconsequential. 

 

2. ETFs increase correlations and harm diversification 

Our work with the ETF Research Academy to better understand the impact of ETFs on their underlying markets shows ETFs influence the aggregate levels of risk in the market, but don’t necessarily increase it.

ETFs don’t automatically cause higher volatility nor do they necessarily increase the tendency of stock prices to move in sync. A parallel can be drawn between the growth of ETFs and passive management and the decrease of return dispersion in the underlying markets over the last 20 years, but we don’t subscribe the view that one definitely caused the other.

Dispersion can be influenced by multiple factors other than index-related instruments, among them global volatility, futures and derivatives, or systematic strategies and algorithmic trading.

 

3. ETFs add to volatility 

How ETF traders affect the underlying index is a familiar debate. The effect ETF “noise traders” – less well informed investors – have on index volatility is relatively short-lived. Trading by more informed investors has a greater impact on financial markets, and plays a role in price discovery over the long run.

The percentage of bond issues held by ETFs is small, and ETF ownership of bonds tends to be associated with more liquid and less volatile underlying bonds. Research suggests ETF ownership may actually reduce the price volatility of constituents in the corporate bond market.

 

4. ETFs make markets less efficient 

New ETFs can help make markets more efficient if they are built the right way – and adding new ETFs to those already in issue can reduce systemic risk. Therefore, the overall level of risk of the market does not depend on the number of ETFs in existence or the size of their assets under management.

That said, ETF issuers can, via their design choices (index weight, methodologies, primary market liquidity), influence the overall riskiness of the market and their impact on market efficiency. Although market-cap indices increase the amount of macro-based information included in financial assets, ETFs on non-market cap weighted indices include a significant micro-based information part in the investment decision process and therefore contribute to pricing efficiency.

Assets in these kinds of ETFs are growing faster than the market overall. And we expect them to be one of the main drivers of ETF market growth in the future.  

 

5. ETFs increase market susceptibility to major drawdowns

Our research into the primary and secondary markets in Europe suggests assets are being traded less, so ETFs are being held for longer.  If they are, it reduces their potential impact on financial markets.

We know investors are concerned by this possible impact, especially when markets are under stress. Such periods of stress can be found (albeit infrequently) in the US, but are, so far at least, impossible to find in Europe. The key question then is will that change any time soon?

In our view, the answer is no - the markets are still too different. The ETF market in Europe may have doubled in the last four years, but it’s still four times smaller than in the US. There are also more checks and balances in place. There are other differences too, including the users of ETFs. In the US, usage is much more widespread among retail and hedge fund investors as well as institutions; we don’t see that in Europe yet.

Providers in Europe have to publish the value of the fund on a daily basis and also publish an indication of the NAV throughout the day (the iNAV). Meanwhile, exchanges such as Euronext also have measures in place to prevent trading from drifting too far from fair value. Some providers then add specific risk rules that go even further to try to limit any ETF impact. This is something investors should be aware of when making their selections.

Lyxor, for example, won’t allow any of its ETFs to be more than 2% of the free market float of the underlying pieces. And the volume of shares traded must not be more than 30% of the average daily trade volume of the underlying parts.

 

Read more

For a more comprehensive review of these five key questions, read our special report from our

   Head of ETF Research,

   Marlene Hassine Konqui 

  



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