The proliferation of exchange traded funds has introduced potentially systemic risks into financial markets and is discouraging new companies from listing on US exchanges, according to the Kauffman Foundation, a US charitable body devoted to entrepreneurship.
“As more ETFs are created, the risk grows that, in the event of a future market meltdown triggered by any number of possible causes, the rush to unwind the ETFs will aggravate any sell-off,” said Harold Bradley and Robert Litan, authors of a report titled Choking the recovery: Why new growth companies aren’t going public and unrecognised risks of future market disruptions.
Messrs Bradley and Litan said ETFs posed systemic risks to the stability of financial markets in two distinct ways.
Firstly, the ease with which ETFs could be used for short selling (betting on share prices falling) made them “ideal potential triggers” for sharp falls in stock markets as experienced in the US “flash crash” of May 6.
A second, less recognised danger, according to the authors, was the potential for ETFs to be caught in a “short squeeze” if investors were to decide that they wanted to close out short positions.
The Kauffman Foundation said that if an ETF failed as a result of a short squeeze, this could “easily trigger a run on other similarly situated ETFs, in turn leading to a marketwide panic”.
The report also said that the rapid proliferation of ETFs had driven up correlations between stock prices and argued that this demonstrated that “no attention” was being paid to the performance of individual companies, undermining the efficient allocation of financial capital.
“To the extent that investors view the ETF as a substitute for buying the individual stocks, then ETFs may actually reduce liquidity in the underlying stocks,” said messrs Bradley and Litan.
They claimed that chief executives of some small companies had demanded promises from exchanges that they would not be included in stock market indices.
The Kauffman Foundation also said it might be “a good idea” for US regulators to ban ETFs whose holdings were not easily traded by precluding small companies from inclusion in any ETF.
Get alerts on Exchange traded funds when a new story is published