ETFs Become the Investing World's No. 1 Scapegoat

(Bloomberg View) -- Despite saving investors about $20 billion a year in costs and taxes on capital gains distributions, exchange-traded funds are being blamed for most everything these days -- even things that haven't happened yet. In the past six weeks alone, ETFs were accused of being weapons of mass destruction, creating a stock market bubble, holding stocks hostage, being hideous, making the market dumb and causing trading glitches. Most of these are histrionics from threatened parties that can be largely refuted with a few pieces of contextual data, but the last two do point to a more legitimate concern.

Let's start with the WMD, hostage and bubble claims, which are essentially the same attack: ETF flows are causing mindless buying of stocks regardless of fundamentals and this will end badly.

Aside from the question of whether there even is a stock-market bubble, ETFs can't be guilty because they are tools, not catalysts. The Federal Reserve, an expanding economy, rising earnings and, more recently, President Donald Trump's potentially pro-business agenda are what is causing stocks to rise. This is why blaming a stock bubble on ETFs is like blaming MP3s for Nickelback or One Direction.

As for being WMDs or holding stocks hostage, ETFs simply don't own enough of the stock market to be a systemic risk or even alter the fundamentals in any significant way. The U.S. stock market's total value rose from $10 trillion in 2008 to $27 trillion today. In that time, ETFs that invest in equities grew from $300 billion to $1.7 trillion. Even with all their growth they still only own little more than 6 percent of the equity pie.

OK, but what about the fact that index funds and ETFs are taking all the flows lately? That matters, right? Perhaps, but let's say ETFs didn't exist and all the flows were going into active mutual funds instead. The money would be buying up the same stocks more or less -- albeit for a much higher fee. For example, the top 10 holdings of the actively managed Fidelity Magellan Fund are pretty close to the top holdings of the Standard & Poor's 500 Index.

This brings us to what is really happening here. The flow of money into ETFs doesn't represent some mad rush to a specific asset class or sector; it's simply a change in formats to access the same thing. Using the MP3 metaphor from above, just as consumers are still listening to music like they did 20 years ago, it's just now at a fraction of the cost and in a more flexible format. With ETFs investors are still exposed to Apple Inc., JPMorgan Chase & Co. and Facebook Inc. -- it's just at a fraction of the cost in a more flexible, tax-efficient wrapper. In short, money is being transferred from closet indexing to actual indexing, from high cost to low cost.

So why are ETFs such a popular scapegoat? First, they pressure on fee revenue and livelihoods of active managers. For example, the asset manager who likened ETFs to WMDs runs a fund that has underperformed its benchmark by 62 percentage points over five years. We've seen similar attacks from underperforming hedge funds over the years. It's important to look at the messenger. I'm still yet to see ETFs get attacked from someone who actually uses them.

Second, it's cool to try and call the next internet bubble or subprime collapse. You'll look like a genius if you are right --  with a shot at getting in the next Michael Lewis book -- and you lose no credibility if you are wrong. ETFs -- as well as passive investing in general -- are a popular target for this crowd. Much of this springs from a lack of understanding about ETF's regulatory structure and mechanics, including the creation and redemption process.

This brings us to what I consider to be a legitimate worry about the growth of ETFs: all the trading.

Although ETFs only own 6 percent of the stock market, they account for about 30 percent of trading volume -- double what it was 10 years ago. ETFs arguably suck up volume from the securities they track like a liquidity vampire. If more and more people stop trading stocks and bonds in favor of ETFs, it will drive up trading costs in the underlying securities while potentially making it more difficult to exit on big sell-off days.

Another trading worry is that ETFs -- and modern markets in general -- are dependent on the grid and its plumbing. ETFs had problems trading recently after a software update at the New York Stock Exchange failed. This was just another reminder that in order for ETFs to trade properly, the exchanges have to be working perfectly with market makers getting all their inputs (pricing for stocks, bonds, derivatives). So if any part of the grid goes down or even has a glitch, as we've seen in the past, ETFs are almost sure to be affected.

And you can bet they'll get the blame.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Eric Balchunas is an analyst at Bloomberg Intelligence focused on exchange-traded funds.

1. ETFs also get compared to CDOs (collateralized debt obligations) and derivatives a lot. But those are instruments with counterparty risk, whereas an ETF is structured like a mutual fund under the Investment Company Act, with assets physically held with a custodian.

2. Not only does trading ETFs a lot pose potential issues for market, it likely will cost investors' money. Studies have shown investors who trade too much tend to lose money.

3. This isn't to say there hasn't been any work done on this front. After Aug. there were many tweaks to exchange rules that have helped. Anyway, individual stocks also can be affected by trading breakdowns on exchanges.

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Eric Balchunas at ebalchunas@bloomberg.net

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James Greiff at jgreiff@bloomberg.net

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