Why you shouldn't blame ETFs for wild marketsJanuary 27, 2012: 5:00 AM ET
Critics say the popular funds are causing stocks to swing wildly together. Finding proof is another matter.
FORTUNE -- Are exchange-traded funds a prime culprit in one of the signature afflictions of the markets today -- the tendency of huge swaths of stocks or other assets to swing dramatically up or down at the same time? Critics are pointing their fingers at ETFs. But evidence for their nefarious role is lacking.
There's no question ETFs have become a market phenomenon. There are now more than 1,110 in the U.S., according to the Investment Company Institute, up from 200 in 2005. ETF assets in this country have topped $1 trillion -- double where they were in 2008.
ETFs are like mutual funds in that they hold a basket of stocks or other assets (often mimicking an index), but unlike mutual funds in that they can be traded throughout the day. That allows investors to move rapidly in and out of, say, a group of tech stocks. And that's precisely what many investors do. ETFs now account for 30% of trading volume on U.S. exchanges.
That volume has raised suspicions. Harold Bradley, chief investment officer of the $1.9 billion Ewing Marion Kauffman Foundation, argues that ETFs boost stocks' volatility and their tendency to move in lockstep (known as "correlation"). "As these products have increased, correlations have been increasing every year," Bradley says, citing research from J.P. Morgan that shows that S&P 500 stocks moved together 60% of the time even in a calm 2010 period -- double the historical average. When stocks move together, Bradley claims, it undermines the essential role of markets: to pick winners and losers. He admits he can't prove that ETFs cause volatility. "But it's like smoking," Bradley says. "You can't prove that smoke is causing lung cancer, but by gosh, a lot of people get lung cancer who smoke."
Others are particularly worried by leveraged ETFs, which use derivatives to amplify bets. These instruments "corrupt the markets by exacerbating price trends" both up and down, wrote hedge fund manager Doug Kass of Seabreeze Partners in an article on the Real Money Pro website this fall. The issue has caught the attention of a U.S. Senate subcommittee, which held a hearing in October to investigate ETFs and their role in stock volatility; the SEC is also investigating.
ETFs make an easy target. But dig a bit deeper and the picture seems different. Yes, they account for a lot of trading volume. But much ETF trading never results in buying or selling the ETFs' underlying stocks, according to Morningstar. We'll spare you the technical details, but in broad terms it amounts to baskets (i.e., the ETF) being traded back and forth while the contents (the underlying stocks) don't trade. In other words, it's effectively a wash. And for all their growth, ETF assets are still tiny compared with stock futures and options. They're too small to have outsize effects in the $17 trillion U.S. equity market, says Jason Hsu of Research Affiliates, whose strategies are used to manage $78 billion.
Moreover, "ETF trading spikes on those high-volatility days," says Eric Noll, head of transactions at Nasdaq, who scrutinized market moves last year. "But so does trading in every other security." In his view, ETF trading isn't driving the market -- it's responding to it. Noll asserts that ETF trading is probably improving markets by allowing sizable pools of risky investments to find new holders quickly.
Morningstar analyst Michael Rawson recently examined two of the most pilloried incarnations: leveraged and inverse ETFs (the latter use derivatives to profit from falling markets). If those funds cause volatility, Rawson theorized, their asset base should swell or shrink before the market's spikes and swoons. But his research showed that assets have stayed remarkably constant since 2009. For example, from Nov. 15 to Nov. 25, when the S&P 500 (SPX) fell seven consecutive days and posted a total loss of 8%, assets in inverse and leveraged ETFs remained at $34 billion. "That stability flies in the face of the volatility argument," he says.
So what's really driving the violent price moves? You can't discount the obvious: Investors are agitated -- and particularly prone to follow one another -- in the face of a weak U.S. recovery, the European debt crisis, and slowing Asian economies. Morningstar's Rawson offers a more prosaic explanation: company profits. In periods of higher earnings volatility (such as the past three years), stock volatility is considerably higher than in periods of stable earnings (as between 2003 and 2007). Such explanations are perhaps less satisfying than fingering ETFs -- but they may be more plausible.
The five biggest ETFs
1. SPDR S&P 500
Assets: $95.4 billion
2. SPDR Gold Trust
Assets: $63.5 billion
3. Vanguard MSCI Emerging Markets ETF
Assets: $41.7 billion
4. iShares MSCI EAFE Index Fund
Assets: $36.5 billion
5. iShares MSCI Emerging Markets Index Fund
Assets: $32.5 billion
This article is from the February 6, 2012 issue of Fortune.