Serious ETF Drawbacks?

In the last few days there have been quite a few commentaries posted that explore the downside to ETFs. Obviously I have been a big proponent for the wrapper for the access they provide and the democratization of certain strategies. Additionally I have tried to point out various drawbacks as I have seen them, noting that no investment product is perfect and no product can be the best single way to access every part of the market. I have also been clear about how I use ETFs for clients while noting that I use more individual stocks than ETFs.

We are all starting to learn more about their drawbacks and learning about what appears to be new drawbacks as well. One of the big complaints from investors in the last couple of years has been about correlations seeming to go up, some have even quantified this and for now correlations are indeed higher. Some of the blame for this is starting to be attributed to ETFs. It makes sense when you think that for each new creation unit the underlying equities need to be bought either right away or shortly there after for any funds that might use other derivatives as a temporary stopgap to fill the customer order.

This makes a tail-wagging-the-dog argument and while the intent of this post is not to quantify this there is some plausibility here. Let's take Schlumberger (SLB) which based on yesterday's closing price and average daily volume has $522 million in dollar volume. This stock has a 7.5% weight in the Energy Sector SPDR (XLE) and a 12% weight in the Oil Services HOLDR (OIH) and the dollar volume in SLB from those two funds adds up to $81 million or 15% of the dollar volume in the common and that is just two ETFs. While the mathematical process is not airtight it gives some idea of the potentially significant effect that ETPs can have on individual stocks--at least I think it is significant.

If there is anything to this (you can decide for yourself) then it means that ETFs cause a distortion in how markets function and this distortion could be thought of as an unintended consequence for the ease of access and democratization that makes the funds so popular. ETFs are also being heavily criticized for having more clearly erroneous prints during the flash crash than equities meaning a larger percentage of existing ETFs mispriced than with equities.

I don't have much to say about the flash crash because it seemed obvious right away that something was not functioning correctly, I posted as much right in the middle of it with a little humor and added to an ETF position for a lot of clients about ten minutes too early. And as I rarely use stop orders (it has been a while since the last one), a lot of people got hurt by having stop orders elect due to "bogus" prices, I am not too concerned about the event. Not that it wasn't a very bad thing that should be investigated, just that it is not something I have spent any real time on, nor will I.

Ok well there are still some benefits to ETFs. A lot of benefits actually. While I don't think this constitutes talking my book, but you may disagree, the distortions caused by ETFs support my beliefs about top down construction, more foreign exposure and an investment time horizon that looks a little further out than lunch time.

It is a good bet that the long term prospects for Baoviet Holdings, the largest component of the Market Vectors Vietnam ETF, client holding, will not be compromised by high frequency trading, creation unit abuse (I don't think that is a real term) or anything else related. The company will succeed or flounder over the next few years based on the economy where it functions and the quality of the management decisions--another violent panic like the flash crash will not change that even if it were to distort the price for a day or two.

On May 6 Creditcorp (BAP) a big Peruvian financial company opened at $82.46. The low for the day, presumably around 2:40pm was $77.69 for a max drop of 5.7%. It closed the day at $80.62 down 2.2%. If you had been away for the day and BAP was your only holding (intentionally extreme example) you'd have never known there was a problem. The Chilean stock we own for most clients was down even less at its low point that day and both are up a ton since the close that day compared to down a couple of points for the S&P 500.

Four months is not really long enough to make a fundamental argument for those stocks going up but life for them went on and to the extent investors are losing faith in the US market (I don't know how true that is but a lot of people talk about it) things in Peru and Chile seem to be carrying on without us. This is a point I have made countless times, if the US ends up being a less attractive investment destination than other countries the merits of those countries will be recognized in equity prices.

Again, four months is not much time but this can be a microcosm. The US hasn't blown up, it has simply been flat versus up a lot for some other places and ETFs for these countries have been a way for investors to capture those moves despite all of the drawbacks cited above.

One more colorized, depression era photo from the Denver Post. When I first saw this one I thought "it looks a lot like Northern Arizona," turns out to be New Mexico.