ETFs, financial stability and the invisible hand

Warnings about the risk that the widespread use of ETFs entails for the proper functioning of financial markets are widespread. The criticism, no matter whether genuine or motivated by interests, is fundamentally based on two complementary narratives: the “dumb money” distortion and the “house of cards” risk.

The first points to the misallocation of capital caused by investors blindly pouring capital into index-tracking strategies. If investors stop discriminating between good and bad businesses, innovation and entrepreneurship would be disincentivized, dampening the creative destruction that underpins the capitalist system; a sort of socialism by the back door.

The second narrative refers to the risks for market stability posed by the exponential growth of ETFs. The main problem is that these instruments are often not backed by direct ownership in the securities that make up the underlying index, but they are replicated with derivative contracts. This allows the volume invested in these assets to be much higher than that of their reference indexes. The fear is that in a time of market panic there may be massive requests for reimbursement, without there being enough underlying positions in the market to sell and return the money back to investors.

And now, the two narratives merge into one: given that the emergence of ETFs has made it easier for retail investors to access less liquid asset classes, such as high yield or emerging market bonds, which were previously outside their scope. And because retail investors have a tendency to buy euphoria and sell in panic, market fluctuations are exacerbated, causing markets to be inherently more unstable.

These arguments, although they have a logical appearance, are just a remix of old misconceptions about how markets work, intentionally disseminated by those who have more to lose by the success of ETFs. For example, swap-based ETFs are not different from any other derivative contract, such as futures or options, which have been an integral part of financial markets for decades. In addition, if investors tend not to control their impulses, this would affect both ETFs and mutual funds alike.

In fact, with the empirical evidence accumulated so far, the arguments about misallocation of capital and market stability are mutually contradictory. If passive investors buy and sell indiscriminately, active investors will be able to exploit the many arbitrage opportunities that will be presented to them. This should help both to stabilize the market and to improve active managers’ returns. Given that, as is known, most fund managers perform in line with the market, either the distortions caused by ETFs are minimal, or retail investors are not as dumb as they are supposed to be.

Ironically, the arguments can be turned around, resulting in a much more plausible explanation: it is active managers and speculators who, in their pursuit to generate alpha, constantly try to anticipate the next turn of the market; overreacting to the flow of news and, therefore, destabilizing the market.

In contrast, retail investors are afflicted by one of the most ingrained behavioral biases: the inability to sell positions at a loss. Normally, these are individual securities in poorly diversified portfolios, which often turns out to be a poor investment decision. However, when this strategy is applied to diversified ETFs, not only does it drastically improve expected returns, but it indirectly contributes to improving financial stability; a sort of “invisible hand” providing support to financial markets.

Fernando de Frutos, MWM Chief Investment Officer


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