ETF Fail

Exchange Traded Funds (ETFs), another source of supposedly benevolent liquidity, were among the worst performers on the day of the May 6th, 2010 "Flash Crash".

According to this Barron's article, ETFs made up 70% of securities where the trades had to be cancelled.

Some assert that ETFs add liquidity and, as a result, reduce volatility. Well, they may actually be adding to volatility.

They certainly appeared to add to it on May 6th.

ETF volumes have exploded over the past decade and, in just the past few years, a bunch of leveraged ETFs that allow any investor to go 2x and 3x short or long using derivatives have been launched. These new tools have been controversial for good reason:

1. They do not function as some might expect over a longer time horizon. I use the term longer time horizon loosely here (i.e. more than a day). Using that criteria for longer time horizon probably speaks volumes about how crazy this has all become. In 2009, Bespoke Investor Group pointed out that the 3x Leveraged Long Financial (FAS) ETF had dropped -63% ytd through July 16th while 3X Leveraged Short Financial ETF dropped -88%. During that period, the Russell 1000 Financial Sector Index was down only -2%. Wow.
2. Margin requirements are there to keep the amount of leverage used to buy stocks within acceptable limits. These ETFs are designed to get around those rules. How does this kind of liquidity reduce volatility?

Excerpt from the Bespoke Investment Group post:

In a period when the Financial sector is down 2%, not only is the 3x bearish ETF down, but with a decline of 88%, it is also down more than the leveraged long ETF! So even if you correctly anticipated the direction of the Financial sector at the start of the year, you would have lost your shirt if you used these ETFs to implement your strategy.

Saying these extreme ETFs don't function properly seems quite an understatement. They should probably be reined in but that's probably not going to happen anytime soon.

In this Bloomberg article, John Bogle had the following to say about extreme ETFs:

Bogle...says these complex securities subvert the discipline of buy-and- hold investing and encourage investors to chase market-beating returns by speculating like day traders.

In the article, Bogle added...

"It's insanity," says Bogle, 81, the founder of Vanguard Group Inc. "This is a classic case of Wall Street trying to capitalize on the worst instincts of investors."

Traditional ETFs, bought when prevailing equity values are fair and held for long periods of time are excellent low cost ways of investing. The problem is they are predominantly not being used that way.

On the other hand, extreme ETFs seem to just increase volatility. They seem to encourage the renting of stocks over ownership.

Adam

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