The Perils of ETF Volatility

NEW YORK (TheStreet) -- John Bogle, founder of Vanguard Group, has been a longtime critic of exchange-traded funds.

Because ETFs are easy to buy and sell, they can encourage investors to trade rapidly, Bogle wrote in his book Common Sense on Mutual Funds. Constant trading can be a recipe for poor returns.

When he began attacking ETFs a decade ago, Bogle was a lone voice. But lately more critics have appeared.

After stocks plunged in the Flash Crash of May 2010, some observers argued that high-frequency trading of ETFs had added to the turmoil.

Criticisms erupted again this year when analysts said that the increased use of ETFs caused the big market swings in August. Analysts say that ETFs have distorted markets, driving individual investors away from stocks.

Concerned about the charges, the Securities and Exchange Commission has begun investigating rapid trading of ETFs.

Whether or not the SEC finds a smoking gun, it is clear that the enormous growth of ETFs has helped to reshape markets.

There are now more than 1,000 ETFs with $1.1 trillion in assets, according to the Investment Company Institute. That is a big jump from the figures in 2000 when there were 80 funds with $66 billion in assets.

While retail investors have embraced ETFs, much of the growth can be traced to institutions and high-frequency traders who constantly buy and sell.

ETFs have proven to be ideal vehicles for high-frequency traders. The funds can be shorted or used to profit from small moves in the benchmarks they track.

Now that they have become favorite holdings, ETFs account for 40% of all exchange trading.

The structure of ETFs encourages volatile market moves, says Harold Bradley, chief investment officer of the Ewing Marion Kauffman Foundation, which manages a $1.7 billion endowment.

ETFs represent baskets of stocks or bonds that can be traded on exchanges like stocks.

With a single key stroke, an ETF trader can buy the 30 stocks of the Dow Jones industrial average or the 500 companies of the S&P 500.

Bradley says that in the past an investor might buy several small-cap stocks that seemed promising.

Now an ETF trader can buy a fund that covers 2,000 stocks. When investors become nervous, they dump ETFs and send strong stocks down along with weak ones.

Because of heavy ETF trading, all small stocks now tend to rise and fall in unison, Bradley says.

In a report, Bradley and Robert Litan concluded that the volatility of ETFs was depressing the number of initial public offerings. Convinced that markets would not reward strong companies with higher share prices, small companies were electing to remain private.

The report recommends that the SEC should bar ETFs from holding small-cap stocks.

Besides discouraging promising companies from raising capital, volatile trading could lead to more market crashes. Complicated ETF trading "looks a lot like the financial engineering that created the mortgage mess," the report said.

Proponents of ETFs counter that the funds are not responsible for the debt burdens in the U.S. and Europe that are slowing economies and roiling markets. Advocates argue that ETFs offer low-cost tools to implement strategies.

Although many ETFs can be sensible choices for retail and institutional investors, the industry has been introducing portfolios that are increasingly volatile, says Don Phillips, president of fund research for Morningstar.

Phillips divides the history of ETFs into three time periods. Before 1996, ETFs were generally broadly diversified portfolios that tracked common benchmarks such as the S&P 500. The average ETF was about as volatile as the S&P 500 as measured by an indicator known as standard deviation.

From 1996 through 2005, 150 funds were introduced. These included narrower choices that tracked industry sectors and single countries. The narrow choices tend to bounce sharply up and down, delivering outsized gains and losses. The average volatility of the second crop of funds was about 25% higher than the figure for the S&P 500.

Since 2005, more than 1,000 ETFs have been introduced. These include leveraged ETFs, which deliver double or triple the returns of a benchmark. The most recent crop of ETFs is about 40% more volatile than the S&P 500. "It's alarming how much more volatile ETFs have become," says Phillips.

Phillips concedes that leveraged and specialized ETFs may be appropriate vehicles for sophisticated investors. But he worries that the most volatile funds can backfire on retail investors. All too often retail investors rush to buy funds that have been leading their categories. But in today's erratic markets, the hottest funds can quickly turn cold and deliver big losses.

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Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.

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