Exchange traded funds have grown like topsy over the past few years and are popular both for there low costs and liquidity. ETFs that track indexes are particularly popular with investors who see no point in risking the possible underperformance of a more expensive fund manager.
Assets held in ETFs have tripled since the year 2000 to around $1.7 trillion last year. According to Morningstar ETFs cost an average of 0.57 per cent of assets to operate annually. Compare that with 1.26 per cent for the average actively managed mutual fund.
There is also the liquidity of ETFs to consider. They trade at the touch of a button on global financial markets and do not suffer from redemption periods.
However, there could well be a nasty sting in this tale. ETFs are increasingly being used by large financial institutions to mimic the performance of hedge funds, albeit more cheaply and with instant liquidity.
So far so good but what happens in a market correction? The instant liquidity of ETFs mean more sell buttons being pushed simultaneously than ever before. Can the markets really handle this or will the third parties running the ETFs be left holding the ball?
If nothing else ETFs are likely to lead to greater market volatility because of the elimination of natural market stabilizers like redemption delays. This could prove particularly irksome in an upcoming stock market correction because the Federal Reserve’s room to cut interest rates further is almost zero.
Lest we forget in normal stock market corrections of above 10 per cent the standard response is for the Fed to take the axe to interest rates and for markets to bounce back. That is not going to be possible with interest rates already down on the floor.
In 1987 computer trading programs were blamed for the severity of the October crash. You have to wonder if ETFs will not be blamed for making the next stock market event worse than it otherwise would have been.
Stock market innovations have a nasty habit of biting the hand that feeds them. That understood ETFs that bet in a contrarian or short fashion are likely to be the new best friends of investors in any upcoming sell-off.Again whether such ETFs can really handle the inevitable sudden inflows is going to be interesting to watch, and it maybe that these investments prove less liquid than advertised in a meltdown.
Disclosure: No positions