New Funds, Familiar Fears: Do Exchange Traded Funds Make Markets Less Stable? Part I, Liquidity Illusions

Abstract

Since the 2008 global financial crisis, exchange traded funds (ETF) have exploded in popularity. An ETF is an investment product that tracks an underlying index or basket of assets, like securities, bonds or commodities, but unlike mutual funds it trades like a stock. Many view ETFs as superior to mutual funds since they give average investors low-cost instant diversification in a product that can be bought or sold throughout the trading day, with a single click of the mouse, on a national stock exchange like the NYSE. ETFs will likely house a sizeable share of American retirement savings in the future, while being a preferred vehicle for institutional investors, high-frequency traders, and algorithmic wealth managers (robo-advisers). And yet, ETFs present a potentially worrisome paradox. They offer the benefit of near-perfect liquidity - the ability for investors to buy or sell quickly with low transaction costs – but this liquidity could prove illusory when it matters most: during a stock market crash or a full-blown financial crisis.

This two-part study investigates “interaction risks” in the ETF market. Part I shows how ETFs create potential liquidity risk by operating in a complex ecosystem that is dependent on the discretionary behaviors of intermediating financial institutions. Case studies on 1980’s portfolio insurance, and the 2008 auction rate securities market failure, will show that reliance on discretionary actors to provide liquidity, and perform arbitrage, in a crisis can be illusory and fragile. It’s impossible to predict exactly how (or when) a new crisis will arrive. Yet the popularity of ETFs as an asset class, how they increase the connection between main street, Wall Street and pensions, their potential liquidity risks, and the long-term uncertainty that passive investing is having on the economy, make ETFs a prime candidate for heightened consumer financial protection, regulatory, and academic attention.

Keywords: exchange traded funds, liquidity, interaction effects, investor herding, systemic risk, financialization, supply side innovation, tragedy of the commons, market complexity

JEL Classification: K22, K24, O16, P12, G02, G14, G20