The first U.S.-listed ETF, the SPDR S&P 500 ETF Trust, was launched after five years of negotiations. In the quarter-century since, ETFs have been a positive force by reducing trading costs, improving market efficiency and adding liquidity to the market.
So why have critics suddenly decided that the original key design feature of ETFs is a flaw?
Some reasons are rational. The actual record of ETFs in market disruptions of the last five years has been mixed, especially in August 2015 when a volatile market exposed some issues with ETF pricing and trading. This argues that ETFs can be improved, and cautions that they won’t solve all market problems. Also, the original conception of a single market factor ETF has evolved into a huge variety of specialized ETFs which might fragment liquidity in a crash rather than concentrating it.
But the main reason is transference. It is entirely rational to fear panics and crashes. They happen. They hurt. ETFs do not prevent them, nor anesthetize the pain. There is good reason to think ETFs can help limit crashes to the fundamental economic realignment that drives them, reducing collateral damage and contagion. But that’s by no means certain. Each crash teaches us new stuff, and sometimes the new stuff is the opposite of what we expected.
So people transfer their fear of financial meltdowns and pin it on ETFs. ETFs are designed to be our friends in a crash, and economic theory argues that they will be, but they’re new and not fully tested and bad times sometimes cause us to turn on our friends.
The Bloomberg Opinion piece was written by Aaron Brown, a former managing director and head of financial market research at AQR Capital Management.