The Market's Latest Scapegoat

Despite the blame exchange-traded funds (ETFs) have received, there's little to indicate they're responsible for the market's recent struggles

Sep 30, 2015 at 7:00 AM
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Way back in the dark ages of finance -- the '80s -- there was a market crash. There was no Twitter to sarcastically comment on it ... or brag about how short you got right before everything imploded. There was no Instagram to show what you were eating while the market crashed. There wasn't even an Internet, unless you were a scientist of something. There were no CBOE Volatility Index (VIX) calls to race into. In fact, there was no VIX -- any numbers you see from 1987 are backdated calculations.

But there were designated scapegoats. That hasn't changed much over the years. One scapegoat was stock index futures. The pre-algos of the day would execute trading programs in the futures as an arbitrage play. It provided an easy way to buy and sell "the market" at once. The second scapegoat was portfolio insurance.

"Portfolio insurance is an investment strategy where various financial instruments such as equities and debts and derivatives are combined in such a way that degradation of portfolio value is protected. It is a dynamic hedging strategy which uses stock index futures. It implies buying and selling securities periodically in order to maintain limit of the portfolio value. The working of portfolio insurance is akin to buying an index put option, and can also be done by using listed index options."

The idea sounded great, until the market started tanking -- at which point, portfolio insurance required even more selling. The increasingly popular futures were the most liquid and easiest way to "insure" the portfolio. That brought in the program traders buying futures at steeper and steeper discounts and hitting every stock bid they could as part of the arb. It all snowballed into a debacle.

I bring this up because we're in the midst of some serious ugliness -- and, of course, we need a scapegoat. And lately I keep hearing the scapegoat is exchange-traded funds (ETFs).

Like futures 28 years ago, ETFs can add to volatility. When times are rough, it's pretty common to just hit the figurative "button" to sell something quickly, then maybe sort out the details later. And as ETFs become a bigger and bigger part of the market, it stands to reason they can have a bigger and bigger impact.

But as a cause of all this? Please.

They add to correlation by the mere fact that stocks in a popular index will correlate a bit more as the ETF itself gets more popular. A basket trade will just trade them all in one nanosecond. And correlation is akin to volatility, as far as the index is concerned.

But ETFs are long in the tooth at this point. The SPDR S&P 500 ETF Trust (SPY) came out in 1993, just to name one. Lots of the popular sector ETFs, like current "poster child for volatility" iShares NASDAQ Biotechnology Index ETF (NASDAQ:IBB), came out in the '90s. Some flopped. Remember the B2B sector? The ETF was huge in the late '90s, now I can't remember the symbol offhand. Many have just grown and grown. And the overall growth of the industry has been pretty persistent over the course of time.

And yet, market volatility has not trended higher over the course of time. If the preponderance of ETFs literally caused volatility, then I'd expect to see at least some sort of relationship between ETFs as a share of the marketplace and index vol. Yet, I haven't seen one.

I do believe ETFs can add to vol on the margins. Again, it's going to add to correlation, and correlation equals vol. Perhaps they contain volatility at other times. I don't really know. I do know that there's no particular, concrete reason to blame them for the current market woes.

Disclaimer: Mr. Warner's opinions expressed above do not necessarily represent the views of Schaeffer's Investment Research.


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