Samuelson: Understanding the ETF debate

By The Daily News

WASHINGTON – Can we make sense of ETFs?

If you’re in the investing class, you doubtlessly know that ETF stands for “exchange-traded fund.” Along with index mutual funds, they track a given stock or bond index. The best-known ETFs mirror the Standard and Poor’s 500 stock index. If the S&P 500 goes up, so do various ETFs tied to the S&P 500 index. If the S&P 500 goes down, so do the ETFs.

The appeal of the ETFs for individual investors is that they virtually guarantee returns equal to whatever index is being targeted.

Not only that, but the management fees of index ETFs and index mutual funds are usually much lower than the fees for traditional actively managed mutual funds. These are overseen by investment “advisers,” who buy and sell different securities. The fees for these actively managed funds can run up to 1 percent or more of the funds’ assets. By contrast, management fees for the “passive” funds are one-fifth of that or less.

Because traditional mutual funds have a hard time matching the returns of broad-based stock indexes, the ETFs are widely considered a good deal for individual investors. In recent years, there’s been a proliferation of index funds that track the stocks of various sectors of the economy (health care, finance, media) as well as bonds and commodities.

Not surprisingly, these funds have experienced enormous growth. The Securities and Exchange Commission approved the first ETF in 1993. In 1996, the number of index funds totaled 124 with a total value of $100 billion. By May 2018, the number of ETFs and index funds had grown to 2,063, worth $6.9 trillion, reports the Investment Company Institute (ICI), a trade group for mutual funds and ETFs. (These figures consolidate both ETFs and index mutual funds.)

Growth is expected to continue. A recent report from Black Rock, a large financial management firm, said that the total value of index funds could hit $12 trillion in five years.

So what’s to worry? Just this: As ETFs and index funds grow in number and size, they might make the stock market more unstable. In Wall Street jargon, the market might – or already has – become more “volatile.”

A case in point: Stocks fluctuated erratically last February amid fears of higher inflation and interest rates. In one two-week period, the Dow dropped 3,200 points or 12 percent, reports CNN. Some commentators contended that increased sales of ETFs and index funds compounded the market’s movements, driving stocks down further. By the same logic, ETFs might accentuate higher stock prices by buying shares when the market is rising.

Although this sounds straightforward, what happened in February is very hard to prove one way or another. In a study, economist Shelly Antoniewicz of the ICI disputed the conclusion. For starters, the ETFs and index funds constituted only 13 percent of all U.S. stocks’ value in 2017. Yes, it’s true that trading volumes of ETFs increased in February, but they also rose among other investors.

What really drives stock prices, she contended, is new information, either economic or political – whether involving interest rates, presidential pronouncements, business developments, profits or the like – that causes investors to re-evaluate their outlook.

Another more recent study by S&P Global Market Intelligence, a research group, takes a more middle ground. It also examined what happened in February, and in a highly mathematical appraisal, decided that “as much as one-third of the [stock] pullback” reflected pressures from increased ETF trading. But the effect is temporary and reversed itself after three to five days, the study said.

The ongoing debate bears watching because it raises the perverse possibility that what seems a boon for individuals – more and cheaper choices for stocks – may work against the common good because it makes the stock market more volatile. It’s an unhappy prospect.

This article provided by NewsEdge.