Are ETFs Causing Increased Volatility?

Brittney Barrett |

U.S. securities regulators have been investigating whether the increase in massive exchange-traded funds has been responsible for the intense volatility of the market in 2012.  Officials from the Securities and Exchange commission interviewed firms trading ETFs earlier in the year as a means of uncovering whether the introduction of these sorts of funds, which now generate between 35 or 40 percent of exchange trading volume, could be responsible for the steep swings the market underwent in 2011.

The market seems to be becoming more difficult to read, as subtleties that might indicate a change or reversal are now magnified, as exemplified by the weeks of 400 and 500 point swings in the market in later 2011. The rising popularity of ETFs is being suspected as a source. Exchange traded funds, designed to track market indexes while trading like a stock, can sometimes amplify the impact of a bet through the use of derivatives. Ask most people to explain the impact of derivatives, and they will struggle to conceptualize exactly what falls beneath that umbrella. The best definition is perhaps financial contracts with values tied to the asset they trade under. Derivatives can result in returns two or three times the return of the index it is tracking. As a result of the complicated nature of derivatives, regulation and investigation of the exact impact can be a struggle.

As of September 2011, the suspicion was that the buying and selling ETFs and the user of derivatives by highly active traders for the purpose of making quick returns is resulting in heightened volatility. While the source of the volatility could also be related to unprecedented influences, including the reduction in the U.S. credit rating or the impact of the European debt crisis, regulators are suspicious that ETFs could be amplifying the expected volatility further. There are differing opinions about how the use of ETFs changes trading. ETFs can be bought and sold at a variety of times, either at market open or before close, with the intention of rebalancing a portfolio or mid day in order to benefit from the trends in the market that day.  Some argue the amount of money in each individual ETF is not large enough to have a significant impact on the market.

All in all, the SEC and the investing public seem divided on whether ETFs are having a notable impact on the economy and its difficult to design a system for regulation when its near impossible to create an equation in which their impact can be tested on the market without other factors influencing.

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