ETF Investing: Why ETFs can’t be blamed for the correction or volatility in stocks

ETF Investing: Why ETFs can’t be blamed for the correction or volatility in stocks

The U.S. stock market suffered its worst week in months this week, with major indexes dropping into correction territory for the first time in about two years. Was the phenomenal popularity of exchange-traded funds a contributing factor to the weakness or the scale of the decline?

This is a question that has been hotly debated for months, particularly as ETFs continue to be among the most widely used securities on Wall Street. While ETF advocates argue that the funds simply track the market, as opposed to leading it, skeptics have long warned that the concentration of assets within ETFs would exacerbate market moves and lead to indiscriminate selling in the event of a downturn.

Read more: Fears grow that popularity of ETFs is a ticking time bomb

Equity ETFs track baskets of securities like mutual funds, but trade intraday like stocks. The investment vehicle is dominated by passive products, which simply mimic the performance of an underlying index like the S&P 500 SPX, +1.39% holding the same stocks the index does, and in the same proportions. Currently, 6.97% of the U.S. stock market is held by ETFs, according to data from Toroso Investments.

“The numbers simply don’t support the idea that the rise in ETF ownership is creating a world where everything is correlated,” said Michael Venuto, co-founder of Toroso Investments. “Remember that ETFs were a fraction of their current size in 2008 [during the financial crisis], but you had the same kind of broad selloff we saw this week. When ETFs own about 20% of the market, that’ll be a different story, but right now they’re too small to have this kind of impact. People are throwing the baby out with the bath water.”

The basic argument that ETFs worsened the decline is this: because investors essentially buy and sell the whole market with each trade, heavy selling would mean that all stocks in an index were sold, regardless of each individual stock’s fundamentals. This past week was certainly marked by heavy selling, particularly in ETFs and other stock funds. According to global fund tracker EPFR, investors pulled $30.6 billion out of equity funds in the week through Wednesday, the largest weekly outflows ever.

The stock-fund withdrawals were heavily concentrated in ETFs; per FactSet, stock-based ETFs saw outflows of $20.45 billion over the past week. Among specific funds, $17.5 billion was pulled from the SPDR S&P 500 ETF Trust SPY, +1.47% while the iShares MSCI EAFE ETF EFA, +1.53%  had $2 billion in outflows. However, those two fund categories were also the most popular: the iShares Core S&P 500 ETF IVV, +1.33%   had inflows of $1.8 billion over the past week, while $1.7 billion went into the iShares Core MSCI EAFE ETF IEFA, +1.53%  .

According to ETFGI, global assets for exchange-traded products (which includes both ETFs and the much smaller category of exchange-traded notes) surpassed $5 trillion at the end of January. Global assets first cracked $4 trillion in April 2017; the entirety of last year represented a record-breaking year of growth for the trading vehicle.

Despite that growth, Venuto is right that ETFs represent a small part of the market, dwarfed in size by mutual funds, international investors, retirement funds and households. However, that small part of the market is also one of the market’s busiest, and ETFs dominate among the most actively traded securities of any type.

According to the WSJ Market Data Group, four of the five most widely traded securities this week were ETFs, led by the SPDR S&P fund, the market’s oldest and largest ETF, which had more than 1.2 billion shares exchange hands. (Total composite trading in the week topped 54.5 billion shares, making for the most active week since one ending in August 2011.)

In October, Eric Balchunas, an ETF analyst for Bloomberg Intelligence, estimated that on days with heavy selling pressure, ETFs comprise about 40% of total trading volume. However, only 10% to 20% of ETF trading on those days actually involves the underlying securities, as opposed to simply exchanging shares of the fund. He speculated that ETFs may even limit market declines by providing additional liquidity into the market.

Read more: Why ETFs won’t cause, or worsen, an 1987-style stock-market crash

This past week has seen a rise in stock correlations, meaning individual names are moving in tandem rather than trading on their own fundamentals. According to data from S&P Dow Jones Indices, correlations for the components of the S&P 500 stood at 0.517 on Feb. 8. That’s up from 0.166 on Feb. 1, and it is above the long-term median read near 0.35. Perfect correlation, where everything moves exactly in sync, would result in a reading of 1.0, while no correlation would be expressed as a reading of 0.

The rise in correlations would suggest the heavily used ETFs are having an impact, but correlations have been nonexistent prior to the recent decline, in some cases coming in at 10-year lows. That has occurred despite the massive growth and adoption of ETFs, suggesting their usage isn’t creating market inefficiencies.

And of course, there were fundamental reasons behind the week’s selling. The downward pressured started in earnest with the release of the January jobs report last week, which showed an acceleration in wage growth. That led to concerns that inflation was returning to markets after a multiyear absence, and that the Federal Reserve might be more aggressive in raising interest rates than had previously been anticipated.

That pressured defensive stocks like utilities and telecommunications, as the so-called “bond proxies” are seen as less attractive to income-seeking investors at a time of higher bond yields. At the same time, some of the market’s recent leaders — including a number of names in cyclical sectors — also sold off heavily. In other words, investors had reasons to sell stocks across a variety of sectors; the rise in correlations can’t simply be pinned to ETFs.

Mustafa Sagun, chief investment officer for Principal Global Equities, credited what he called passive strategies for the week’s decline, but stressed he was talking about volatility-based tactics, and not traditional beta funds, which the most popular ETFs qualify as.

“Such volatility strategies are not price sensitive, meaning they don’t buy and sell the market based on fundamentals. Instead, when volatility goes up, they have to lower their risk, which means they have to sell stocks, and that selling begets more selling. I don’t see ETFs as contributing to this,” he said.