SPDR ETFs: Before you ask, the market sell-off wasn’t ETFs’ fault

Oct 15th, 2018 | By | Category: Equities

By Matthew J. Bartolini, Head of SPDR Americas Research.

Like Sean Maguire comforting Will Hunting, “ETFs, it’s not your fault”.

Like Sean Maguire comforting Will Hunting, “ETFs, it’s not your fault”.

Benjamin Franklin got it wrong when he proclaimed, “Nothing can be said to be certain, except death and taxes.” He forgot about ETFs being labelled as culprits for market sell-offs. I haven’t checked yet, but I am sure the onslaught of articles is coming, specifically mentioning how the SPDR S&P 500 ETF (SPY US) recorded $60 billion of secondary market value in trading on Wednesday, equating to roughly 30% of the dollar volume on the New York Stock Exchange.

The pundit who loves a good hot take will no doubt latch on to that data point, telling anyone who will listen that, “Surely a number this large must be pushing prices around!” The reaction to that statement, however, should be met with a response similar to the one Willy Wonka had when he informed Charlie that he and Grandpa Joe had violated the section 37B clause of their contract when they stole Fizzy-Lifting Drinks: “Wrong, sir! Wrong!”

Like Sean Maguire comforting Will Hunting, “ETFs, it’s not your fault”.

As we pointed out in February when the market was gripped with an inflation irritation that sent US stocks tumbling by 10%, ETF primary market activity (the activity that actually leads to underlying stocks being moved) resulted in a small percentage of underlying stock volume. On 5 February, one of the year’s more frenetic trading days that saw the S&P 500 Index fall by 4%, the gross primary market activity (creations plus the absolute value of redemptions) was just 3% of all stock volume.

At the time, we pondered the question: How can something that represents 3% of the market lead to the stock market falling more than 4% on a single day? That same question holds today because the data is exactly the same.

Yes, roughly $166 billion of shares changed hands in the secondary market for any ETF that had a geographical exposure to the US, according to Bloomberg Finance. However, not all secondary market transactions lead to primary market creations/redemptions—the transactions that necessitate an action taken at the single-stock level. As we did in February, to gauge the actual impact of primary market transactions on single stocks, we looked at the absolute value of the redemptions and creations to calculate order flow. We then compared that number to the total volume on individual stocks, using the Russell 3000 Index as our proxy for the market.

What did we find for 10 October 2018?

  • There were $11 billion of gross primary market transactions ($5.5 billion of creates, $6 billion of redeems)
  • Total volume on Russell 3000 stocks was $304 billion
  • This equates to a paltry 3.6% of volume in Russell 3000 stocks that are likely the result of an ETF transaction
  • On a net basis, flows were net negative at -$500 billion, so a lot of the volume from primary market transactions could have theoretically resulted in offsetting order flow

Key takeaway: During periods of market volatility ETFs’ secondary market provides additive liquidity to investors seeking to efficiently transfer risk while reallocating portfolios and market exposures in real time. The creation/redemption process limits the impact on underlying stock prices because many of the secondary market transactions do not result in primary market activity where underlying stock shares are being traded. Ultimately, once again, the activity witnessed on 10 October is another example of ETFs providing valuable tools for clients to build portfolios, transfer risk, and allocate capital with efficiency, transparency and precision.

The three likely main reasons for the market sell-off—and none of them are ETFs:

  • Stuck in neutral: Federal Reserve Chairman Powell’s comment on being “far from neutral” put the market on notice that the Fed will likely continue hiking interest rates as labour markets remain tight, and growth and inflation have begun to perk up
  • Re-rating: Higher rates have pressured equities as investors re-calculate and discount the present value of future cash flows
  • Trade war still on: While trade tensions may have cooled with our friends north and south of the border, relations with China remain as icy as a night in Winterfell. A few materials and industrials companies have already begun to report margin and revenue impacts from rising costs. While fiscal stimulus may have jump-started earnings growth broadly, the rise in protectionism may disrupt supply chains and limit growth.

Three other talked about market sell-off catalysts to consider:

  • Political Schadenfreude: The midterm election effect may have been pushed out as the Supreme Court confirmation process dominated the DC political news flow. In years where a midterm election is held, market returns have historically been negative in August and September. This has been the case since 1962. Perhaps the negative impact was punted to October and we are feeling those effects now.
  • Buyback gating: With earnings season around the corner there is a blackout period for companies to buy back their shares. Without this embedded buyer in the market, stock prices lost support and began to fall. Firms with large buyback plans did underperform the broader market in recent weeks with 34% of the underperformance explained by stock-specific factors (not sector or style). While a reduction in buyback activity didn’t help, I don’t think buybacks were the smoking gun.
  • Profit taking: Perhaps after witnessing a market top propelled by narrow leadership—where only three sectors outperformed the broader market and just slightly more than half of the S&P 500 stocks were trading above their 200-day moving average—winners were sold as investors took profits ahead of year-end tax season planning. Momentum was the worst performing factor on the 10th.

What’s next?

Fundamentals are still strong, and valuations are not stretched. Regionally, it’s all about the US. However, Japan has had positive price and earnings momentum coming into the fourth quarter. Overall though, the US has better economic and fundamental growth prospects.

Ultimately, the dust will settle, and companies will start to report earnings, a season that is projected to be the third in a row with 20% plus growth. Focusing on firms with positive earnings revisions and a strong track record of earnings surprises may be ideal.  This means continued positioning with Technology and seeking defensively oriented growth with broad Health Care.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)

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