The rapid growth of exchange traded funds has over concentrated the ownership of thinly traded stocks, led to an increasing number of trading failures, and could trigger another “flash crash,” according to Jason Zweig’s Wall Street Journal article, “Are ETFs a Menace?or Just Misunderstood?”, citing a report by distinguished researchers at the Kauffman Foundation.
The Kauffman Foundation report contends that ETFs are “radically changing the markets,” and could lead to a “panic-driven market meltdown,” according to the article.
ETFs are funds that hold a basket of securities (often all the securities in an index) and trade like a stock.
With regard to over concentration, the article reports that while the iShares Russell 2000 Index Fund is not over concentrated in the sense that no one stock represents a large portion of the ETF, it is among the 10 largest holders of 1,737 stocks?many of which also are held by other iShares ETFs. Since index-tracking ETFs must buy the stocks in the index they track, regardless of price, prices of the underlying securities may become more inflated than they otherwise would be as these ETFs come to dominate the market.
With regard to liquidity, Zweig says investors should not take that for granted in thinly traded markets.
On the subject of trading failures, more buy orders for ETF shares are failing to “settle,” or going uncompleted, according to the article, again citing the Kauffman Foundation report.
Zweig, however, disagrees with the report’s conclusion that ETFs pose a systemic risk. The report apparently contends that ETFs might run out of cash if they had to buy during a “short squeeze,” when stock prices can spike upward as traders scramble to cover their short positions by buying more shares, which, in turn, could trigger a systemic panic.
“The risk of short selling is not inside the ETF,” Gary Gastineau, who helped develop ETFs at the American Stock Exchange in the early 1990s and now runs ETF Consultants in Summit, N.J., was quoted as saying, adding: “As an investor in the fund, you’re not subject to those risks; you’re protected from those risks.”
“I’m confident that the structure of ETFs mitigates the risk of the short squeeze that [the Kauffman authors] are concerned about,” Leland Clemons, a director in the capital-markets group at iShares, the largest ETF sponsor, was quoted as saying, adding: “It cannot happen.”
Zweig hedges this “no systemic risk” conclusion by cautioning that the inner-workings ETFs are opaque and not well understood even by veteran investors.
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