Why S&P 500 ETF Investors Over-Reacted to the Recent Market Selloff

NEW YORK (Fabian Capital Management) -- Selloffs in the market generally create fear and over-reaction as investors digest the news and reposition their assets to weather the storm. Despite the good intentions of buying low and selling high, the tendency for traders is to protect profits and preserve capital whenever possible.

That may be one reason why we have seen such as over-reaction in the SPDR S&P 500 ETF (SPY) during this most recent bout of summer volatility. Over the last two weeks, SPY fell 3.84% from high to low on a closing basis. It has since recovered nearly 1.5% of that modest drop.

Despite this relatively benign move so far, investors have been selling SPY in droves.

According to data from ETF.com, from Aug. 5 to Aug. 11 SPY saw net outflows of over $10 billion. This statistic easily placed it in the top of all exchange-traded fund distributions during that time frame. In addition, this single week of selling nearly doubled the total redemptions in SPY to $21 billion this year alone. That represents an approximately 12% reduction in assets year-to-date for this bellwether ETF.

It’s worth noting that similar index funds such as the Vanguard S&P 500 ETF (VOO) and the iShares Core S&P 500 ETF (IVV) both are still experiencing net inflows so far this year. VOO has increased its asset base by $4.5 billion, while IVV has gained $3.6 billion. These ETFs have modestly smaller expense ratios than SPY, but track the same 500 large-cap stocks. Both competing funds also have the advantage of being offered commission free at a variety of major brokerages as well.

So what is driving this selling?

One aspect that may be exacerbating this effect in the current climate is the length of time the market has gone without a typical 10% correction and remained above its 200-day moving average. It has been years since either even occurred, which may be creating itchy fingers on the sell button to try and time the next bearish cycle.

In addition, this bifurcation in asset flows amongst similar ETFs may signal that SPY has become known as more of a trading vehicle because of its history, liquidity and notoriety. The three-month average daily trading volume on SPY is 87 million shares, which translates to a notional value of nearly $17 billion exchanging hands every trading session. This is type of liquidity is particularly important for institutional traders and hedge funds that need to get in and out of the market with size and speed.

The assets flowing into low-cost index funds at Vanguard and iShares may be earmarked for long-term investing themes rather than short-term trading vehicles. That’s not to say that in a steep sell off we wouldn’t see fund flows from these ETFs as well, but the evidence seems to support bigger fluctuations of buying and selling in SPY.

It’s also worth noting that Vanguard equity ETFs represent 5 of the top 10 funds for inflows so far this year. Both retail investors and advisers are continuing to embrace low-cost indexes with built in incentives such as waiving trading fees to build core positions in their portfolios.

Despite these recent outflows and over reaction to the selloff, I believe that SPY will retain its crown as the world’s largest and most liquid ETF for years to come. If the market resumes its uptrend, this cash will likely be put back to work in other sectors or focused opportunities. The Energy Select Sector SPDR (XLE) and Health Care Select Sector SPDR (XLV) are the reigning sector leaders in new inflows this year and may continue to attract new assets moving forward as well.

At the time of publication, the author held no positions in any of the stocks mentioned, although positions may change at any time.

Follow @fabiancapital

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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