The Rise of ETFs and The Fall of Diversification
In 2021 nearly all investors, retail and institutional use ETFs for their exposure. What they are and how they have changed the way that the markets have behaved for decades, is what we are discussing today.
What is an ETF
An exchange-traded fund (ETF) is a type of security that tracks an index, sector, commodity, or other asset, which can be purchased or sold on a stock exchange the same as a regular stock. An ETF can be structured to track anything from the price of an individual commodity to a large and diverse collection of securities.
ETFs have been listed on the US stock exchange since 1993 with the launch of an ETF tracking the S&P 500 index. Since then, the floodgates of new ETFs, and public participation in them, has driven ETF AUM (assets under management) to over 7 trillion US dollars, see (figure 1 and 2).
Figure 1
https://www.visualcapitalist.com/the-26-year-history-of-etfs-in-one-infographic/
What makes ETFs so attractive? Before the rise of ETFs, the retail investor would have to hire a financial advisor or deal with complicated software to obtain exposure to just a single asset class. Today we can purchase a diversified security to an asset class with only one ticker symbol. This has allowed for something like the Sleep Well Portfolio (SWP) to be traded by an everyday investor from the comfort of their office chair, sipping their morning coffee. Before the rise of ETFs, it would have been nearly impossible to run something as complex and dynamic as the SWP.
With the public participation in ETFs over the last decade growing, we have begun to see an interesting trend…the amazingly popular passive investing craze. Investors all over the world are relying on ETFs more every day, whether allocating to them by choice or through a financial advisor that uses them for a overall financial plan. With this trend, we see the largest ETFs beginning to behave differently than in the past. One that we are discussing, in particular, today is one that the SWP has exposure to, SPY.
The S&P 500 index has been used as a barometer for how well the stock market is doing in general. With the rise of ETFs, we see the ability to trade in and out of these 500 stocks in an instant starting to change the original idea of the index. When the retail investor and so many institutions trade one asset like the SPY, we get behavior that no longer reflects the broad diversification that an index offers, and more price action like a single stock. Indexes have always been known for steady movement and very few gaps overnight. With the ability for investors to trade SPY during off-market hours, things are drastically different today. Since 2012, we have seen an ever-increasing occurrence of overnight gaps in the S&P 500 index, something that was almost extinct in the time period between 1990-2007. Even before 1990 gaps we rare, happening once a week at best. Today we see gaps every night and with a magnitude never before seen in the index’s history. Pair all these gaps with the extreme movements we see during public announcements, like fed meetings, and we get behavior resembling a single stock at earnings time.
As ETFs bring a plethora of benefits to the retail investor, they also bring new challenges as they influence financial markets. Those challenges can be overnight gaps, larger intraday swings vs close to close distance, or even spike volatility that comes as fast as it goes. Soon it might be called for to separate an asset class into a few ETFs with different holdings to achieve the desired result for diversification in a single asset class. Today we all enjoy the power of ETF investing and the ability to manage an extraordinarily complex portfolio with only 6 assets with the SleepWell Portfolio.
