Are ETFs really Passive?

What is an ETF

Most people have heard of ETFs but not everyone knows what they are. An ETF is an Exchange Traded Fund and they are extremely popular amongst retail investors and novice investors. Companies such as Beta shares, Vanguard, Blackrock and others create and manage these holdings on behalf of investors. An ETF is a collections of stocks that is grouped together to generally replicate the structure and weighting of an index such as the ASX200 or the Nasdaq. Alternatively, an ETF can also be a collections of assets that represents a sector or industry such as an Energy ETF. The market for ETFs has grown substantially with new ETFs being created regularly. The value for ETFs in the USA by the end of November 2021 was worth 3 Trillion dollars.

The advantages of investing in ETFs is that they are generally well diversified and that they don’t require constant administration or management. In addition, they are seen as being relatively passive as holders of shares of the ETF do not need to manage the buying and selling of the holdings of the ETF. Many ETFs offer dividend reinvestment plans included many investors will not look at their holdings for a long time.

The truth of ‘Passive’ Investing

Are ETFs really passive? The reality is ETFs require a great deal of management and administration. The managers of the ETFs must constantly adjust their holdings accurately to reflect either the rules of the ETF or the weighting of the companies on the index. Therefore instead of the ETFs seemingly operating independently they are actually constantly changing all the time. Some ETFs will adjust by buying or selling shares at the end of the trading day. As indices rebalance, usually every three month, six months or 12 months, the ETF must reflect those changes.

The ‘Flow’ on effect

The issue is when an Index rebalances, the ETF is required to buy or sell the stocks that are being removed or added. As ETFs have such large holdings in the individual companies their buying and selling can often have quite a strong effect on the price flow of the shares. This problem is exacerbated with ETFs that hold small cap companies. These smaller companies are even more at risk of a run by an influx of money coming into an ETF’s buying/selling patterns. This can lead to undesirable outcomes as the managers of the ETF must fight themselves to reach their required buy/sell volume of assets.

Potential Issues

Blackrock is one of the companies that creates and hold ETFs in various sectors. One of its ETFs tracks 30 energy stocks. At one stage it held 8% of the shares of one of its holdings of one stock. The cashflows from investors into the ETF were artificially driving up the price of the stock. Essentially, with so many shares to buy and sell, the ETF is ‘fighting itself ‘to fill its orders. This sees a very sharp increase/decrease in price usually with large volume. In response to this unique problem the S&P Dow Jones Index in consultation with Blackrock created new rules for holdings to be added to the ETF and improve liquidity.

For traders, ETFs create potential trading opportunities because as the old saying says “follow the money”. The ‘liquidity vacuum’ that ETFs create can often be quite aggressive moves to a stock’s price action substantially.