Are ETFs Hurting Your Stock?

A boon to investors, exchange-traded funds may dampen demand for small-cap shares and pose systemic risks.

Investors have poured money into exchange-traded funds by the bucket load in the past decade. But regulators are beginning to question what kinds of systemic risk these investment vehicles - which trade like stocks - harbor. They are also trying to understand how ETFs affect the share prices of the companies whose stocks they index. Both issues should be of concern to CFOs.

Similar to a mutual fund, an ETF tracks a basket of securities, like the Russell 2000. But ETFs are also highly liquid, because they trade like stocks, the price fluctuating throughout the day. ETFs had $1.2 trillion of assets under management as of 2010, up from less than $75 billion 10 years ago, said the Financial Stability Board (FSB) in an April 2011 paper, "Potential Financial Stability Issues Arising from Recent Trends in Exchange-Traded Funds." There were 2,379 ETFs as of 2010, up from 92 in 2000, according to a comprehensive report on ETFs last year by the Ewing Marion Kauffman Foundation.

For the month of September, the trading volume of ETFs and their debt-market cousin, exchange-traded notes, reached $2.1 trillion, about 36% of all U.S. equity-trading volume, according to the National Stock Exchange, an electronic stock market.

The market has exploded. But ETFs may inhibit the proper functioning of the capital markets and rob individual stocks - small-cap ones - of liquidity. The evidence for the first charge: the rising correlation of stock price movements during the decade of the ETF boom. Securities of different companies are more often moving in the same direction at the same percentages - as much as 60% of the time, according to some studies.

A high correlation in common-stock performance, the authors of the Kauffman Foundation paper write, is a signal that the markets are "paying no attention to the performance of individual companies" and are not "properly allocating capital between different assets of financial instruments in such a way as to properly discipline risk and reward success."

ETFs also harm small-cap stocks, the foundation paper says, because hedge funds and other investors have turned to small-cap ETFs to get exposure to the sector. Trading an ETF is cheaper and allows the investor to enter and exit the exposure instantaneously. Meanwhile, many of the small-cap stocks in these indices are illiquid. If there is a massive sell-off in an ETF, the ETF provider may have to unwind the instrument by selling the underlying securities. "Who will buy the underlying instruments when this happens?" the Kauffman Foundation asks.

Consider an analogous situation that could occur with an ETF based on gold. The SPDR Gold Shares ETF holds more than 1,280 tons of bullion, "more than most central banks," says the Kauffman Foundation. The ETF gives investors a way to easily trade gold, but gold is normally not easily tradable. "Once retail investors decide to sell gold, will sovereign funds stand there with outstretched hands saying, 'Let me take this off your hands'?" asks the foundation paper.

Sophia J.W. Hamm, an assistant professor at Ohio State University's Fisher College of Business, says the tendency of less-informed investors to put their money into ETFs rather than individual stocks is hurting liquidity. At the top level - the market for all individual stocks - "we don't really know what the net effect of [ETFs] is," says Hamm, who published a paper on the subject in August. "But on the markets of individual stocks, yes, [ETFs] are a negative. They decrease liquidity."

The systemic-risk issue with ETFs comes from the growth of "synthetic" ETFs. Highly prevalent in Europe, synthetic ETFs don't generate investor returns by holding a basket of stocks. Instead, they enter into an asset swap - an over-the-counter derivative - with a counterparty to replicate some kind of securities index, like the S&P 500.

The ETF provider, often a bank, has to back the ETF with a basket of collateral. That collateral, however, doesn't have to match the assets of the tracked index. Indeed, it usually consists of less-liquid instruments, such as unrated corporate bonds and small-business loans. According to a letter to European regulators from the CFA Institute, an association of investment advisers, "there is an incentive for banks to sell synthetic ETFs through their asset management branches in order to raise funding against illiquid portfolios of securities which could not otherwise be financed in the repo market, or at a significant haircut."

If the performance of a synthetic ETF falters and investors want their money back, the ETF provider could face problems liquidating the collateral, or finding other means of funding it, forcing the provider or bank to suspend investor redemptions, the FSB says. If the ETF provider honors investor redemptions, it could face a liquidity shortfall institutionwide.

A lot of the proposed solutions to the ETF problem focus on transparency for ETF investors - particularly important where the ETF has counterparty and collateral risk. But the Kauffman Foundation paper suggests that issuers of small-cap stocks examine what they get from being indexed in an ETF. Formerly, a company's executive management wanted its stock to be included in broad indices because it was seen as enhancing the company's stock price. But now that the benefits are questionable, according to the Kauffman paper, issuers should reconsider.

The SEC needs to "restore the balance of power relative to ETFs" by allowing companies to "opt in" to inclusion in an ETF, the Kauffman paper suggests. That might slow the indexation of stocks, especially thinly traded ones "for which the unwind risks in the event of a major sell-off are much greater," the paper concludes.

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