Canadian Investment Review

Siegel: ETFs do not cause market volatility

Written by Caroline Cakebread on Monday, November 14th, 2011 at 10:43 am

rodeo bronco horse(Source: ETF Centre) No other kind of investment has divided investors more than ETFs. Investors love them because they are cheaper and more liquid than mutual funds. On the other hand, a host of critics and a few key regulators think they cause extreme market volatility and that some products (especially the leveraged kind) will ultimately lead us towards some kind of financial market Armageddon.

In this Q&A with finance professor Jeremy Siegel, Institutional Investor seeks out some academic perspective on the issue. Siegel, who teaches finance at the University of Pennsylvania’s Wharton School is also an adviser to ETF sponsor WisdomTree. Which means you need to take his comments with a healthy grain of salt.

Siegel says that ETFs can’t possibly move markets or distort the prices of individual stocks as some critics claim. For one thing, the market is simply too small and even inverse funds can’t possibly be driving prices the way some people say they do.

As he points out:

The volatility we see in today’s markets is not linked to those ETFs. A lot of people who own inverse funds see declining returns, and they don’t understand that the returns are supposed to go down. They don’t understand that inverse funds may be well correlated with oil prices on a day-to-day basis, but over time they get a deteriorating asset. It is sort of like a put. It’s hard to explain to investors. You don’t have a sudden downside, but the price you pay for that is a deteriorating asset. I don’t think ETFs raise the level of systemic risk at all. I don’t understand the mechanism. The size of the ETF industry is still very small compared to mutual funds.

The Q&A makes an interesting read – in addition to tackling the relationship between ETFs and market volatility, Siegel also brushes off concerns over the riskiness of inverse and leveraged ETFs (“The risks are borne by the buyer” he shrugs).

In all, I think Siegel makes a few good points – especially when he notes that the size of the ETF industry is still very small compared to mutual funds.

But is he off base (and possibly showing some bias) on some of his other assumptions? I’ll leave that for you to decide and discuss below….

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