Harold Bradley and Bob Litan made some very good points about ETFs in their Congressional testimony last week — testimony which Paul Amery today greets as “a mixed bag”. But it’s hard to argue with this:
We have enough history with financial innovations to at least raise questions when we see an innovation growing at very rapid rates. ETFs are no exception. We believe that these instruments may now be undermining the fundamental role of equities markets in pricing securities to ensure that capital is efficiently allocated to growing businesses. When individual common stocks increasingly behave as if they are derivatives of frequently traded and interlinked ETF baskets, then it is trading in the ETFs that is driving the prices of the underlying stocks rather than the other way around.
There’s a tragedy of the commons going on here: for any given individual investor, ETFs make a huge amount of sense. But if individual investors — and a lot of institutions, too — all pile into ETFs en masse, then stocks lose their price-discovery role, and large deleterious effects can start emerging.
For instance, one big reason to buy a market index rather than a handful of individual stocks is that the index provides diversification. But that diversification is disappearing as people pile into ETFs:
High co-movement of securities is not new, often occurring when markets reflect crowd panic or euphoria. What is new, however, is how ETFs decrease diversification benefits, with stocks and sectors worldwide moving together, even when there is no panic. Stocks move together today more than at any time in modern market history with recent data indicating that individual common stock prices that make up the S&P 500 index now move with the index 86% of the time.
Here’s one particularly striking chart:
This isn’t the S&P 500, which has even higher correlations. It’s just large-cap stocks. Which are all moving together in lockstep — much more than they were even in 1987, and more even than they were in the Great Depression.
It’s common sense that the more investors buy and sell equities via index trackers like ETFs and futures, the higher you’d expect internal index correlations to be. And since ETFs have been growing in importance, the greater you’d expect their impact on index stocks’ co-movements to be.
Researchers at JP Morgan came to similar conclusions last year, arguing that high-frequency trading is also playing a role in boosting internal index correlations.
There’s nothing forcing investors, by the way, to purchase those index trackers where such herd effects are most prominent. You don’t have to buy the S&P 500—you could easily choose an index put together in different ways and featuring different stocks. Arguably, avoiding “overowned” indices should be near the top of a list of any investor’s priorities.
This I find a bit less convincing. As the above chart shows, there are very high co-movements even outside the S&P 500, it’d be hard to find any kind of broad stock index without a high correlation. And if you only get a small benefit in terms of extra diversification, then the costs, in terms of higher ETF fees for unusual instruments, are likely to be higher than the benefits from diversification.
That said, there are lots of people who make money from the huge amounts of cash sloshing into ETFs, and especially from the way in which the S&P 500 ETFs have to rebalance every time the index changes. And the more popular S&P 500 ETFs become, the more we’re all just funneling cash — some 30bp per year, it’s estimated — to those rebalancing arbs.
What is to be done? At the margin, Bradley and Litan’s idea that ETFs should have tighter circuit breakers than individual stocks is a good one. Amery reckons that “it’s important not to leave loopholes where trading in the ETF is stopped, but that in most of the underlying stocks can carry on” — but I don’t see that. If you want to keep on trading individual stocks, that’s fine — just stop the ETF driving their movement.
But fiddling around with circuit breakers won’t make any difference on a day-to-day basis. And cracking down on ETFs more generally risks throwing the baby out with the bathwater. My feeling is that the best thing to do here is simply adopt the kind of financial-transactions tax that the Europeans are talking about — a 0.1% Tobin tax on all ETF trades. That would drive away the day-traders and rebalancing-arbs from the ETF market, leaving it to the buy-and-hold investors that ETFs are very good for. It can’t do much harm, and it could well do quite a lot of good, from a systemic-risk perspective.