I’ve been spending a lot of time thinking about the effects of the increasing popularity of ETF’s as investment vehicles. Although ETF’s are a fantastic way to make “macro” bets on the market, there are some fundamental issues that may arise in conjunction with their popularity.

1. ETF’s will increase the correlation of a certain sector or basket of goods. This effect may seem trivial at first, but in a state of market deleveraging, or releveraging, they have the potential magnify the correlation effects of market swings. Additionally, because they are marketed as “better alternatives” to mutual funds, because of the significantly lower cost basis, if investors begin to have a greater desire to hold a “market portfolio”, their popularity may continue to rise. 

2. ETF’s funnel cash into equities in their basket blindly based on some type of weighting. Because of an ETF’s primary role to index a basket of securities, investors may be holding companies that they do not truly understand. This lack of information is dangerous, because if these individual companies get bad press and the stock drops, the industry as a whole, due to correlation, might take a larger-than-deserved hit from that information, and the investor could suffer. Additionally, this increased volatility would warrant an increase in the premium of volatility-linked derivatives.

In my opinion, ETF’s create significant market inefficiency, so as their popularity rises, there is more opportunity for investors who can keep an eye out for types of mispricings in individual securities.

For example, if an ETF holds Biotech company A in its basket, and the industry as a whole is doing quite well, but after researching the company you realise that it is doing horribly-yet its stock price is increasing due to this correlation, it might be a good strategy to go short the individual security, and go long the weighted percentage of the ETF (obviously, the spread capture would be smaller, because of a higher correlation). The theory behind this is that the ETF will overvalue the crap company, or undervalue a fantastic company.

In conclusion, I’m short the correlation that these ETF’s are creating as a byproduct of their increasing popularity. I think it will create more irrational market pricing of individual securities. Remember that this reason for correlation is not because of a fundamental rule, like two companies who are exposed to the same market risk, but instead due to the fact that investors have become more lazy and would prefer to hold a market basket, rather than individually analyse securities. 

I’d love to hear your thoughts on this one.