Nearly a year after the 2012 flash crash ignited by a trading glitch at New York-based Knight Capital, investors are still eager to understand what happened under the hood of exchange-traded funds (ETFs), even as the sector continues to grow and prosper. At least, this was my main take-away from a fascinating roundtable on ETFs hosted last week here in Toronto by the Capital Markets Institute and the Canadian ETF Association. Here, a panel of experts shared their views on growth in the industry and the latest academic research. The panel included Eric Kirzner, Professor of Finance, John H. Watson Chair in Value Investing and Director of the Capital Markets Institute, Rotman School of Management; Susan Christofferson, Associate Professor of Finance, Rotman School of Management; Howard J. Atkinson, President, Horizons ETFs Management (Canada) Inc. and Chairman of the Board, Canadian ETF Association; Reginald M. Browne, Managing Director of ETF Team, Knight Capital Group; and Mark Yamada, President & CEO, PUR Investing Inc.
Atkinson pointed out that ETFs, like smartphones, are an interruptive technology that is taking away market share from mutual funds and are occupying a larger space in global capital markets. Faster and cheaper, he said, ETFs make life easier for investors.
As that happens, however, recent academic research has taken a close look at how growth in the ETF space is changing the way capital markets work—some of this research was the subject of a presentation by Christoffersen. With estimates of $8 to $9 trillion of trading in the U.S. tied to an index, she argued, it’s bound to change the dynamics of capital markets. For example, she said, research shows that the price of stocks, including in an index, get pushed up by demand for ETFs and those price changes are permanent. Index inclusion, thus, becomes a factor driving the price of that stock, not just fundamentals and the balance sheet. At the same time, a stock’s deletion from an index can have a negative impact on price.
Christoffersen likened the behaviour of stocks in an index to birds flying in a flock—both the stock price and the index are behaving the same way. When that happens, diversification benefits go down. It also increases the potential for market instability.
It’s a big change—and a permanent one, given the prevalence of indexes and ETFs in the investment world today.
Christoffersen’s overview of the research was refuted by other panellists, notably by Knight Capital’s Brown. He argued that mutual funds, which occupy a much larger space within capital markets than ETFs, can have the same effect as those managers who try to buy the same stocks en masse. So ETFs aren’t alone.
Next week, I’ll continue to summarize highlights from the roundtable, including the role of authorized participants and how key players are betting on active ETFs to foster growth in the industry.