ETFs don’t create scarcity: Vanguard

by , 9th March 2018

As assets have gushed in, ETFs have generated enough myths to shame a Greek god.

Some of these myths – “worse than Marxism”, “a Ponzi scheme” – have been silly. Others – “they free-load on price discovery”, “they blow bubbles” – self-contradictory. (How can something that simply free-loads also blow bubbles?)

But others have been intricate and plausible – like the claim that ETFs make scarce the shares they hold. And scarcity, in turn, drives up prices.

“When the Fed bought up and held a big chunk of the Treasury market…[it made] Treasuries scarcer amid still-healthy demand,” wrote the Financial Times.

“[Wells Fargo] argues that a similar dynamic is happening with ETFs and the US stock market. Given that inflows have been pretty much uninterrupted since the crisis, [and] they hardly ever sell stocks, [ETFs] in practice [reduce] the free-float of shares available for traditional asset managers to buy…In other words, the more money goes into ETFs the fewer natural sellers there are in the market, helping buoy prices.”

Why this is false – at least in Australia – was made clear by a recent analysis from Vanguard.

Most of the money coming into ETFs, it found, was coming from other financial assets, with a lot coming from shares. This means that rather than making shares scarcer, ETFs can make them more available.

“Scarcity is not getting driven up. The money going into ETFs is typically coming from other financial assets,” said Damien Sherman, head of capital markets at Vanguard.

“The flows going into fixed income and international equities ETFs come from financial assets already in the system, such as local equities, cash and high cost active funds. This helps diversify Australian portfolios.”

Vanguard’s analysis also put to bed other worries about the contribution ETFs make to systemic risk. Importantly, this included fears that ETFs would collapse during a flash crash or sudden correction, as has happened in the past.

During the Shanghai Composite crash in August 2015, the creation redemption mechanism, which allows ETFs to track their underlying indexes, stopped working on some ETFs. Market makers, which should have been arbitraging out any discounts, refused to do so for whatever reason. This meant that some funds traded at half the value of their underlying holdings—something which, in theory, should be impossible.

Yet nothing of the sort happened during the February 2018 VIX crash, Vanguard found.

“We saw a lot of creation activity during that week,” Mr Sherman said. “The creations and redemptions mechanism worked very smoothly throughout that period. There’s considerable evidence that during the volatility period ETFs did what you’d expect.”

As volatility shot up, spreads on ETFs did widen, Vanguard found. But only by a few basis points.

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