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Are ETFs causing volatility?

Are ETFs causing volatility?

Trading volumes in exchange-traded funds (ETFs) could be causing volatility in less liquid asset classes, fund selectors have warned.

ETFs are increasingly being used at times of volatility by investors seeking to enact market views quickly. For instance, on January 15, a day when the S&P 500 fell 2.1 per cent, seven of the 10 most-traded securities in the US were ETFs.

Victor Lin, director of Credit Suisse’s quantitative equity trading strategy business, said in a note to clients that daily ETF trading volumes in the US between January 11 and 15 were 40 per cent higher than 2015 averages.

Mr Lin said ETF trading was more correlated to overall volatility than movements in individual stocks, given their use for tactical asset allocation, hedging and shorting.

“When there is greater volatility in the markets and prices are fluctuating with greater frequency and magnitude, more opportunities are created for these market participants to trade due to wider spreads and larger trend deviations.”

While liquid markets such as US equities will not necessarily be affected by this trend, UK fund selectors have suggested there could be some causal link between ETFs and volatility in more illiquid asset classes.

Ryan Hughes, fund manager at Apollo Asset Management, said: “The further you go down the liquidity curve, the more [trading levels and volatility] become self-fulfilling. The more you go down the curve, [volatility] becomes symptomatic of the product.

“I am very cautious of using ETFs for illiquid assets. For high-yield and small-cap equities, I would always use an active manager, because you can get volatility in times of stress.”

Tilney Bestinvest director of investment strategy Ben Seager-Scott said many investors would be increasing their use of ETFs to deal with volatility. This did not mean the products were driving volatility, but this may be the case in some “marginal asset classes”.

He warned: “You could see issues in the less liquid [classes] like corporate bond, high yield and emerging market equities. Trading happens away from the underlying markets, so you could see stress.”

Some have gone further and suggested larger markets may be affected. Last year, after the ‘Black Monday’ of August 24 produced a spike in US ETF trading and a pricing disconnect between the vehicles and their underlying indices, Woodford Investment Management’s Neil Woodford said the products may have been “a significant reason for market volatility and instability”.

However, Morningstar senior passive research analyst Jose Garcia-Zarate said correlation between trading flows and volatility was not significant enough to draw firm conclusions.

“Volatility comes for a reason and it is not the existence of ETFs. You can argue that [ETFs] make it more unstable but you cannot [argue] that it exacerbates volatility.” he said.

Simon Colvin, an analyst at financial information provider Markit, also said perceptions linking volatility and ETFs were down to the growth of the products’ popularity.