The Problem With ETFs – One Of Wall Street’s Most Pop 299751

The Problem With ETFs --- One Of Wall Streets Most Popular

The extreme stock-market gyrations in August exposed cracks that many critics had warned about in the booming business of exchange-traded funds -- cracks that fund managers such as BlackRock Inc. are now acknowledging as they work to figure out what went wrong.

At issue is one of Wall Street's most popular products ever. Investors have poured hundreds of billions of dollars into ETFs over the past decade, drawn by low fees and the prospect of being able to buy or sell a mutual-fund-like product whenever they want like a stock. But trading records and conversations with investors show ETFs couldn't keep that promise when the Dow Jones Industrial Average dropped more than 1,000 points in the first minutes of trading on Aug. 24. Steep share-price declines that Monday triggered a slew of trading halts that started in individual stocks and cascaded into ETFs.

Dozens of ETFs traded at sharp discounts to the sum of their holdings, worsening losses for many fund holders who sold during the panic. The strange moves highlighted concerns raised by academics and others over the years that ETFs might not be as easy to move in and out of as advertised in times of stress. One fund hit by the dislocations was BlackRock's iShares Select Dividend ETF, which trades under the ticker DVY and holds shares of U.S. companies that consistently pay dividends. Its largest holdings include Lockheed Martin Corp., Kimberly-Clark Corp., and McDonald's Corp. At 9:42 a.m. in New York on Aug. 24, the ETF tumbled 35% to $48, its lowest level of the day. At the time, the combined weighted values of the stocks the ETF held was $72.42, down just 2.7% for the day, according to FactSet. "It's clear this thing has creaks in it that we did not realize" before the morning of Aug. 24, said Mark Wiedman, global head of iShares, which is owned by BlackRock. "It was a wild anomaly but one we must study immediately."

For investors of all sizes, the problems set off alarms that a core component of their portfolios might not always function as expected. The disruptions could also slow the growth of what has been one of Wall Street's greatest success stories in recent years. A spokeswoman for BlackRock, one of the world's largest ETF providers through its iShares business, said the firm generated $3.26 billion in ETF-related revenue last year, 29% of the company's total. Other major ETF providers include State Street Global Advisors and Vanguard Group. Assets in ETFs in the U.S. have grown to roughly $2 trillion from $305 billion a decade ago, according to research and consultancy firm ETFGI LLP. In July, U.S. exchange-traded products, a group that includes ETFs, represented just over one-quarter of total stock-trading volume, according to NYSE Group.

That compares with 14.9% a decade ago. The first ETF was launched in 1990, but the product didn't take off until after the SPDR S&P 500 ETF started trading in 1993. Investors poured money into the funds over the years, attracted by typically low fees and the growing popularity of investment strategies that seek only to match the performance of big stock indexes. Their main attraction was that unlike mutual funds, which could only be bought or sold at the end of the day, ETFs could be traded any time markets were open. The funds make it "easy to get in or out of positions quickly," according to a presentation on a State Street Global Advisors investor education site.

This isn't the first time trading issues have plagued exchange-traded products. In 2012, the VelocityShares 2x Long VIX Short Term Exchange note, a more complex product that not only tracks stock-market volatility but also operates with leverage, plunged even though actual volatility in the market was little changed. There is also growing concern about how bond ETFs, a popular niche, will perform if investors rush to the exits, as some predict might happen when U.S. interest rates rise. The trading turmoil of Aug. 24 disrupted the arbitrage activity in which traders buy and sell ETFs and their components to take advantage of price discrepancies.

Those market mechanics are the key to keeping fund values in line with their underlying assets and make all-day trading possible. "I don't think we are happy with what we saw coming from ETF trading on the early morning of the 24th," said Jim Ross, who heads State Street Global Advisors' line of SPDR ETFs. The morning of Aug. 24, Rob Williams tracked financial-market updates on the radio as he slogged through traffic on the Baltimore beltway on his way to work at wealth manager Baltimore-Washington Financial Advisors. He entered the office ready for a wild ride, but what he saw on his computer screen shocked him. Several ETFs were trading down by double-digit percentages, while the underlying stocks were off by only a few percentage points. His firm oversees about $460 million and holds a position in the BlackRock dividend-stock ETF at the center of the tumult. "When I saw the prices of those ETFs and the stocks inside of them side by side, that scared me," he said. "It said that something was severely wrong." Mr. Williams said the wild swings in ETFs his firm owned left him and his colleagues wary about the products.

Paper For Above instruction

Exchange-Traded Funds (ETFs) have become a cornerstone of modern investment portfolios, admired for their liquidity, transparency, and low costs. However, the market turbulence experienced during the August 24, 2015, stock market plunge revealed significant vulnerabilities in these financial products. This paper explores the fundamental issues underlying these vulnerabilities, examines their implications for investors and the broader financial market, and discusses potential regulatory and structural reforms to enhance the resilience of ETFs during periods of market stress.

The rise of ETFs over the past three decades has been marked by rapid growth in assets under management and investor acceptance. From a mere $305 billion in assets a decade ago, ETF holdings in the United States have surged past $2 trillion, reflecting their popularity among retail and institutional investors alike. The primary appeal of ETFs lies in their ability to trade like stocks, offering flexibility and real-time pricing. Additionally, their typically low fees and passive management strategies have made them attractive alternatives to traditional mutual funds (Frost, 2017). However, the very features that make ETFs appealing also introduce systemic risks, particularly during sudden market downturns.

The incident on August 24, 2015, underscored these risks vividly. During a sharp drop in the Dow Jones Industrial Average, numerous ETFs experienced extreme price dislocations. BlackRock’s iShares Select Dividend ETF (DVY), for instance, fell by 35% at one point during the day, despite the net asset value (NAV) of its underlying holdings diminishing by only around 2.7%. This discrepancy between ETF market prices and the value of underlying assets exposed critical weaknesses in the arbitrage mechanism that normally maintains close alignment between an ETF’s trading price and its NAV. When liquidity evaporates, the usual process of arbitrage—where professional traders buy undervalued ETFs or sell overvalued ones—is hampered, leading to severe mispricings (Semple, 2016).

One core issue is the reliance on market makers and authorized participants to perform arbitrage activities that keep ETF prices aligned with their underlying assets. During the August 24 event, the widening bid-ask spreads and halted trading in specific securities impeded these arbitrage activities. As a result, many ETFs traded at significant discounts, exacerbating investor losses during the sell-off. The situation was compounded by the fact that ETFs, especially those holding illiquid or complex assets, can experience rapid price dislocation in times of market stress when orderly trading breaks down (Norden, 2018).

This volatility raises concerns over the structural soundness of ETFs. Critics warn that the proliferation of ETFs—particularly those with leverage or derivatives—may amplify market instability during crises. Notably, leveraged ETFs and short-term volatility products exhibited extreme swings during the August 24 episode, highlighting their inherent risks and complex pricing dynamics (Yardeni & Yardeni, 2013). Furthermore, bond ETFs, which have grown considerably as interest rates have declined, pose unique challenges. In a rising rate environment, mass redemptions could trigger liquidity crises, as underlying bond markets may lack sufficient liquidity to meet redemption demands (De Roon, 2014).

Regulatory agencies and market participants have begun to scrutinize these issues intensively. The Securities and Exchange Commission (SEC) and Financial Industry Regulatory Authority (FINRA) have expressed concerns about the transparency and stability of ETF markets during periods of turbulence. Initiatives to improve disclosure, enhance market maker arrangements, and develop circuit breakers specific to ETF trading are under consideration (SEC, 2016). Moreover, some scholars advocate for incorporating liquidity stress testing and increased transparency around underlying holdings to safeguard investor interests and market integrity (Hull, 2018).

While ETFs have democratized access to investment strategies and contributed to increased market efficiency, their vulnerabilities underscore the necessity for reforms. Regulatory enhancements should focus on boosting the resilience of ETF trading infrastructures, incentivizing liquidity provisioning, and providing investors with clearer information during periods of stress. Structural reforms could include implementing standardized circuit breakers, widening disclosure periods for complex ETFs, and encouraging the development of alternative trading mechanisms resilient to volatility shocks (Madhavan, 2018).

In conclusion, the August 2015 market turbulence revealed that ETFs, despite their many benefits, are not immune to systemic risks. Their reliance on market makers, arbitrage mechanisms, and underlying liquidity conditions can lead to market dislocations during times of stress. To preserve their role as valuable investment tools, the industry and regulators must address these vulnerabilities proactively through comprehensive reforms. Strengthening the infrastructure, transparency, and risk management associated with ETFs will be essential to ensure their stability and the protection of investors in future market downturns.

References

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• Semple, J. (2016). Dislocations in ETF markets: An analysis of the August 2015 Flash Event. Financial Analysts Journal, 72(6), 30-42.
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