ETFs September 19, 2017

    Exchange-traded funds (ETFs) are undoubtedly popular. Are they also dangerous?

    These diversified baskets of stocks, bonds and other assets have been around for less than 25 years, but in that relatively short run they’ve managed to amass some $3 trillion of assets in the U.S., according to the Investment Company Institute.1 In the last 10 years alone, the value of assets held by ETFs has nearly quintupled. ETFs accounted for nearly a third of the trades conducted on U.S. exchanges in 2016.2

    Investors like them because they're easy to trade—like stocks, you can buy and sell them on exchanges—and can provide broad or niche market exposure at a relatively low cost. As a result, investors use them in a lot of different ways: from trading individual ETFs on the market, to holding them in their 401(k)s, to building portfolios with automated investment advisory services—such as Schwab Intelligent Portfolios.

    But ETFs’ seeming ubiquity is also making some market-watchers nervous. Some have said ETFs make markets less efficient and boost the valuations of otherwise unremarkable stocks. Some say ETFs have depressed volatility, while others see the opposite problem and suggest ETFs could cause extreme volatility during crises.

    Are these concerns justified? In general, we don’t think so. Here we explore why some common worries may be rooted in misconceptions.

    Concern #1: ETFs make markets less efficient.

    Many ETFs are designed to track particular indexes, typically by holding the same assets as an index (or at least a representative sample). For example, an ETF tracking the S&P 500® Index might hold a proportional amount of all 500 of the index’s constituent stocks. As a result, most ETFs are considered “passive” investments because decisions about whether to include a particular security in the basket come down to whether it is part of the target index. That structure is part of the appeal because it makes ETFs cheaper to operate than funds actively managed by an investment professional.

    But some observers fear that because such ETFs passively buy assets without regard to prices, they don’t distinguish between good assets and bad. The concern is that such ETFs could lift all boats, whereas markets are normally supposed to elevate only worthy investments and shun the rest. A related concern is that because ETFs buy whole indexes, they could end up making all the assets on those indexes move in lockstep, thereby making markets less diverse.

    Response #1

    This might make sense if all ETFs followed the same strategy, but they don’t. Whereas a broad-market ETF might hold shares in proportion to their weightings on a market-capitalization-weighted index such as the S&P 500, a "smart beta" ETF might focus on a particular slice of the market by tracking indexes that screen and weight stocks according to their dividend payments, volatility or recent stock-price momentum. (Note that smart beta strategies may be less diversified than a market cap strategy.)

    Second, it’s worth noting that even with ETFs’ impressive growth, they still hold just shy of 6% of the U.S. stock market.3 In comparison, mutual funds hold around 23%. Households, pension funds, international investors, hedge funds, and other investors also own stocks. In other words, there are still plenty of parties in the market buying and selling shares for a variety of reasons.

    In addition, the way ETFs are created and redeemed actually tends to make markets deeper and more efficient. Basically, the process involves ETF companies and entities called "authorized participants" (often broker-dealers) working together to buy and sell the assets needed to create new ETF units in response to changes in supply and demand. If there is sufficient demand for an ETF, an authorized participant can buy the underlying assets on the market and create a new ETF unit. Conversely, if investors selling ETFs start to put downward pressure on the ETF valuations, an authorized participant can reverse the process by redeeming shares. The creation and redemption process creates liquidity and is designed to help keep ETF valuations from straying too far from the value of their underlying assets.

    Concern #2: Automated trading systems can cause ETFs to stray far from the value of their underlying holdings, causing markets to break down.

    This is based on ETFs’ performance during the "flash crashes" that hit stock markets in May 2010 and August 2015. In both cases, irregularities in the market triggered orders by automated trading systems that caused ETFs to become disconnected from the value of their underlying holdings. Normally, authorized participants can step in and help bring prices back into alignment. In a flash crash, trading halts and the triggering of automated stop-loss orders can combine to make it extremely difficult to accurately price assets—thereby causing trading to break down altogether.

    Response #2

    Here, the first thing to note is that outside of a few extreme cases, ETF trading has been very orderly and allowed investors to move in and out of markets with ease. As noted above, ETFs account for decent chunk of the trades conducted on U.S. exchanges. Investors who don't trade during a flash crash aren’t affected by it.

    And the authorities have taken steps to respond to the threat of flash crashes. Regulators, ETF sponsors and exchanges have been working together to make sure markets continue to function in moments of stress. The Securities and Exchange Commission has taken all this under consideration and introduced a system of trading halts to help rein in abnormally erratic markets.

    Concern #3: ETFs may be easy to trade, but sometimes the underlying investments aren't.

    The idea is that ETFs’ stock-like liquidity could give investors the false impression that they can "safely" invest in otherwise illiquid or exotic parts of the market. However, price changes in narrow or thin parts of the market can cause ETF prices to swing sharply.

    Response #3

    ETF liquidity is dependent upon the liquidity of the underlying investment. For example, ETFs focused on large-cap stocks will likely be very liquid because the underlying stocks generally are. Conversely, ETFs focused on niche segments of the markets may not be liquid in periods of stress or extreme supply or demand imbalances.

    While it's true that such ETFs come with specific risks, they might also offer higher returns or exposure to otherwise desirable assets. But it's worth handling them with care. They can make sense as part of a long-term strategy, but they're probably not a good choice for short-term investing as it could be hard to sell at a desirable price during a downturn.

    By Anthony Davidow, CIMA®, Vice President, Alternative Beta and Asset Allocation Strategist, Schwab Center for Financial Research.

    How Schwab Intelligent Portfolios can help

    The power of technology enables efficient ETF portfolio construction and monitoring, but the human touch is just as important. While portfolios are automatically checked for rebalancing and tax-loss harvesting opportunities, a team of human traders reviews all recommended trades.

    With this human oversight, we work to ensure the best trade executions for our clients—not just during periods of volatility, but every day.

    1. Data as of 7/26/2017.

    2. Fourth Quarter 2016 NYSE ARCA ETF Report.

    3. Federal Reserve and World Bank data for 2016.

    Investment returns will fluctuate and are subject to market volatility, so that an investor’s shares, when redeemed or sold, may be worth more or less than their original cost. Shares are bought and sold at market price, which may be higher or lower than the net asset value (NAV).

    Past performance is no guarantee of future returns.

    Tax-loss harvesting is available for clients with invested assets of $50,000 or more in their account. Clients must choose to activate this feature.

    Schwab Intelligent Portfolios® and Schwab Intelligent Portfolios Premium™ are designed to monitor portfolios on a daily basis and will also automatically rebalance as needed to keep the portfolio consistent with the client's selected risk profile. Trading may not take place daily.

    Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

    Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors.

    The S&P 500® Index is a market-capitalization weighted index that consists of 500 widely traded stocks chosen for market size, liquidity, and industry group representation.

    Smart-beta strategies may be less diversified than other investment strategies. For instance, a smart-beta ETF might be more heavily weighted in a particular sector or geographical region, which would amplify an investor's losses in the event of trouble in that sector or region.

    The Schwab Center for Financial Research is a division of Charles Schwab & Co. Inc.


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