Have ETFs Distorted the Markets?

08/05/2010 12:00 pm EST

Focus: ETFS

Scott Burns

Director of ETF Analysis, Morningstar, Inc.

Scott Burns, director of ETF analysis for Morningstar, wonders whether the popularity of commodities and emerging markets ETFs has reduced their diversification value.

One of the great benefits of [exchange traded funds] has been how they’ve democratized investing, but, like all things, we are starting to see the unintended consequences of those actions. The question that is often on my mind is [should we] gird ourselves for a new reality that has been changed by the onslaught of new assets chasing returns through ETFs?

Paul Justice touched on this, and I just want to briefly weigh in. I believe that the rush of money into commodity ETFs has thrown the system slightly out of whack and that we have some supply and demand imbalances in the commodity market as a result.

When commodity proponents talk about the power of the assets as portfolio diversifiers, they use a historical record that generally showed the major commodity areas in states of backwarda­tion. (According to investorwords.com, that’s “a market condition in which a futures price is lower in the distant delivery months than in the near delivery months”—Editor)

Now that we have seen three years of rather persistent contango (the opposite of backwardation, when longer-dated futures contracts are more expensive than those expiring sooner—Editor), those assumptions are coming into doubt. Are ETFs the sole cause of contango? Not necessarily, but the rush of money into very specific parts of the futures curve is not helping matters.

Whether commodities retain their diversification prowess is going to have a lot to do with getting those futures curves back into backwardation. Remember, for something to enhance a portfolio, it has to not only have low correlation with the rest of the holdings, but it also needs to generate a positive return.

[Meanwhile,] at roughly $9 billion, iShares MSCI Brazil (NYSEArca: EWZ) accounts for nearly 1.5% of the total assets on the Brazilian BOVESPA exchange. EWZ, combined with emerging-markets juggernauts iShares MSCI Emerging Markets (NYSEArca: EEM) and Vanguard Emerging Markets Stock (NYSEArca: VWO), own approximately 2.5% of the Brazilian market.

Given how much trading activity occurs in these funds, [their] share of trading volume on Brazilian stocks could be as high as 20% of total daily volume. Given that so much of the Brazilian market is in the hands of ETF investors, we can expect the price fluctuations of Brazil and other emerging-markets nations to more reflect investor sentiment in developed markets rather than anything happening with the fundamentals of Brazilian equities.

We saw this at the end of 2008, when assets rushed out of these ETFs, and the local stock markets were crushed, despite the fact that the fortunes of local companies—banks in particular—were nowhere near in as bad a shape as what developed markets were facing.

For the strategic investor, the increase in correlation is problematic and will affect asset-allocation decisions. For the tactical investor, these dislocations for the fundamentals produce excellent buying opportunities.

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