I get a lot of questions from investors about exchange-traded funds, or ETFs. Many investors are curious about whether ETFs should have a place in their portfolios.
Perhaps the best place to start in this discussion is to define what an ETF is.
An ETF is a set of securities put together to track a certain index. One of the more popular ETFs, for example, was constructed to track the performance of the S&P 500. This is the SPDR S&P 500 ETF Trust (NYSE: SPY).
Prior to the creation of ETFs, it was very difficult for an individual investor to actually invest in an index – but now ETFs allow an investor to do exactly that. And even though an ETF is referred to as a fund, it trades like an individual security during the day.
In other words, unlike the holder of a mutual fund, the holder of an ETF doesn’t need to wait until the end of a trading day to get the NAV (net asset value) and trade the ETF.
Sounds like the greatest thing since sliced bread, right? An investment with the diversification advantages of a fund, but with the ability to trade like an individual security during the day? What’s not to like?
Not so fast…
The bull market in stocks will turn 11 years old in a few short weeks. And not coincidentally, the explosion in popularity of ETFs has coincided with the rise of that bull market.
Eventually this business cycle will end, the bull market in stocks will end, and investors will experience a stock market pullback (correction of 10% or more) or an outright bear market (correction of 20% or more).
So how will ETFs react when the next stock market crash comes?
I suspect that investors may have a rude awakening concerning the liquidity of ETFs.
It will be hard enough to trade a large fund like the S&P 500 Trust, but with the myriad ETFs that have sprung up – particularly in emerging stock and bond markets – how will investors be able to exit ETFs where the underlying securities are thinly traded?
Good luck getting out of those when all the holders want to head for the exits…
But there is one area of the financial markets that ETFs have helped notably: the bond market. That’s because many bonds – even those from well-known companies with large bond issues – don’t trade frequently.
And prior to the advent of ETFs (particularly bond ETFs), these off-the-run bonds could be difficult to value, not to mention difficult to trade. Bond ETFs have made the bond market more liquid, even when the bonds making up the ETFs are not.
ETFs can make a difference for small investors, as well as for the broader market. And their growth shows that individual investors are very comfortable owning them.
But ETFs have not been tested in a market crash, and when all investors are headed for the exits – even in something like a regional crash in emerging markets where the ETFs are not very liquid to begin with – watch out…
And remember, for the most security, you can count on steadfast blue chip corporates.