Why ETFs Are Tricky In Times Of Turmoil

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A large part of today’s money is invested in actively managed mutual funds or passive funds, known as Exchange Traded Funds (ETFs). In the recent years, in particular these ETF’s have made a stellar growth and are part of many investment portfolio and 401k’s. The 3 most liquid ETF’s have a combined Net Asset Value of USD 225bn. As such, these instruments play a significant role in the investment flows. This was underlined by recent developments, especially the early morning rout we witnessed this Monday.

Tracking the market

ETFs are a major driver of market direction. For example, when there are a lot of investments (‘inflow’) in an ETF, this fund has to invest these funds in the market. Its mandate obliges the ETF to be fully invested to be able to track the movements of the underlying as close as possible. As a result, for example an ETF which tracks an index, has to buy shares pro rato in the underlying index. On the other side, when a large number of investors are selling their ETF, the fund sees outflow and has to sell its underlying shares (see figure 1).

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Reinforcing market movements

The dynamics of inflows and outflows have the potential to reinforce market movements. In upward trending markets, this is most of the time a steady process. As the saying goes, markets take the stairs up and the elevator down. When everybody wants to exit, things can get nasty with the ETF dynamics. A recent article in the WSJ pointed out to the fact that volume on stock markets tend to concentrate in the first 30 and last 60 minutes of the regular trading hours (i.e. 9.30 – 10.00 am EST and 15.30-16.00). This is also the time of day ETF’s are balancing their assets, based on the flows of the day. So in case investors turn bearish and are heading for the exit in the early phase of trading, matching of supply and demand will disrupt. This is what we saw yesterday at opening: since everybody is selling, ETFs and mutual funds have to join the pack, causing bizarre movements.

More ETF-driven turmoil to expect?

Although US-markets had a relative quiet first half of the year, ETFs were confronted with a steady outflow. For example, the largest and most liquid ETF, the SPDR S&P 500 ETF (SPY) saw it’s number of outstanding shares declining with roughly 20% (see chart below). The outflow implied that SPY had to sell part of its assets.

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Investors should follow the ETF flows closely. For a part the flows are tracking the market. However, outflows indicate that money is going out of the market. Potential weakness may thus be spotted in an early phase. As for now, the trend for 2015 seems to be unfavorable. Be also prepared for extreme moves in the first 30 minutes of trading. Don’t place market orders pre-market, since these orders will be executed at very unfavorable prices. On Monday, a lot of shares and ETF’s showed abnormal price declines in the first minutes of trading, ETF’s were even traded with huge discounts to their Net Asset Value. Not soon thereafter, prices began to normalize. Don’t get caught in the wrong movement.

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