The Unlikely Scapegoat for the Great Recession

It's fashionable to lay blame for all of our economic woes on any number of culprits. But some of the ideas that people have come up with to explain the causes of the financial calamities of the past two years -- as well as ones yet to come -- are downright silly.

Are ETFs really to blame?
Now don't get me wrong: There's plenty of blame to go round for 2008's financial crisis and the ensuing market meltdown and recession. Whether you pin everything on Alan Greenspan or Ben Bernanke, Congress, greedy Wall Street companies, the current administration, or the previous one, you can make reasonable arguments.

But last week, the Kauffman Foundation came out with a report that blamed the rise of exchange-traded funds for a variety of economic problems. Going well beyond the usual criticisms of ETFs, the report blames the funds for the decline in entrepreneurship and the reduced number of initial public offerings by small U.S. companies in recent years.

Here's the argument, in a nutshell: ETFs encourage investors to combine their investments with one another, giving individual ETFs disproportionate concentrations of stocks. The phenomenon is particularly problematic with small-cap stocks, because they aren't as liquidly traded and therefore are more apt to price manipulation when small-cap ETFs are highly in demand among investors. The system, therefore, creates haves and have-nots among small companies; if a prospective IPO doesn't find itself among the highly followed indexes, then it could be out of luck in finding investor interest.

As backup for its argument, the report points out that the iShares Russell 2000 Index Fund (NYSE: IWM  ) is among the top 10 holders for more than 1,700 different individual small-cap stocks. When you combine other ETFs that hold these stocks, institutional ownership can end up dominating the float for a particular company.

What's new?
But the Kauffman Foundation's argument has several flaws. First and foremost is the fact that the index investing style that encourages such concentration didn't start with ETFs. For decades, index-based mutual funds have had the same impact on small-cap stocks. And in many cases, those funds are still bigger than the corresponding ETFs. Whereas the iShares ETF has about $13 billion in assets, Vanguard's Small-Cap Index Fund has $21 billion under management.

Now to be fair, it's true that index membership is seen as a positive for a stock. That's why speculation about whether up-and-comers Netflix (Nasdaq: NFLX  ) and Vertex Pharmaceuticals (Nasdaq: VRTX  ) should give the boot to the old, tired companies Eastman Kodak (NYSE: EK  ) and New York Times (NYSE: NYT  ) in the S&P 500 gets so much attention -- it can lead to big price moves. Getting to join the S&P 500 pushed shares of Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) way up at the time it was added to the index.

But ETFs aren't the only game in town. Index investing makes sense for small investors, but it also creates opportunities for active managers seeking pricing inefficiencies. Within the small-cap space, actively managed mutual funds, as well as hedge funds, private equity firms, and other enterprising investors, constantly sift through thousands of companies to find a diamond in the rough.

Perhaps the most ridiculous argument in the Kauffman report is the idea that ETFs need to be more transparent. The fact is that ETFs are one of the most transparent investments available to investors. ETFs reveal their holdings every day, whereas mutual fund investors only find out every three months what stocks their fund managers are investing in. And while some ETFs own derivative securities that can be difficult for beginning investors to decipher, ETFs at least have to reveal that they do in fact own them -- a far cry from some of the financial excavation you have to do to discover troubling assets on the books of other investment companies.

Lay blame elsewhere
In the end, ETFs only reflect the will of the investors who buy them. Blaming ETFs for economic failures is like blaming slim jims for stolen cars -- they're a useful tool, but the people who use them would come up with some other way to get the job done if they didn't exist.

ETFs aren't the villain. Used well, they can make you wealthy. Click here to read The Motley Fool's free report, 3 ETFs Set to Soar During the Recovery.

Fool contributor Dan Caplinger blames those pesky kids for the bad economy. He owns shares of Berkshire Hathaway and the iShares Russell 2000 ETF. Vertex Pharmaceuticals is a Motley Fool Rule Breakers recommendation. Berkshire Hathaway and Netflix are Motley Fool Stock Advisor selections. The Fool owns shares of Berkshire Hathaway, which is also a Motley Fool Inside Value selection. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. You can blame The Fool's disclosure policyfor knowing as much as you do about us.


Read/Post Comments (3) | Recommend This Article (6)

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  • Report this Comment On November 18, 2010, at 3:33 PM, mrwizard555 wrote:

    pure BS. i could also buy single and fractional shares of sp500 stocks if i wanted to diversify. make more sense for me to diversify with SPY at a huge discount in trading expenses.

    index ETF's really don't count as institutional holders, except for the shares held in a single vault. they are an aggregate of many investors holdings. without some kind of data on the number of "baskets" exchanged into and out of an index ETF, the report is pure bull.

  • Report this Comment On November 18, 2010, at 4:19 PM, khaledmrd wrote:

    Kodak not just transforming to Digital Business consumers, Services and Commercial but patents i think worth far more than their M.Cap, they start to utilize for many companies.

    Hundreds of Patents in Ink Jet, Bubble Jet, Video & Media & Social communication, OLED, 3D, Digital Cameras, Mobile & Wireless devices and Networks and services .

    Their R&D & innovation for tens of years will start to pay off as it is now the time of Digital World

  • Report this Comment On November 19, 2010, at 12:20 PM, bhessel wrote:

    Dan,

    Well…I agree with your conclusion…but not how you got there. It appears that you have misunderstood the main point of the Kaufman report (and totally missed an important secondary point).

    Their main point is that IPOs and concomitant access to the capital markets for entrepreneurial companies are down because the pricing of disparate asset classes has become extremely highly correlated…and they indict the huge weight of money that has moved into index ETFs as the culprit. An environment where asset class pricing is highly correlated is bad for small cap high growth companies because while they are as risky as ever, they cannot generate outsized ROI results for investors in such an environment—and thus are not particularly attractive. The authors of the report demonstrate convincingly that we are indeed experiencing extremely highly correlated pricing, and they assert—contrary to your characterization of their argument—that being included in indices has now become a net *disadvantage* for a small cap company as it increases their stock’s susceptibility to the stultifying high correlation effect. (Quite logically, the authors propose allowing smallcap companies to opt out of being included in indices.)

    They also make an important secondary point, which you have totally ignored: ETFs contribute to systemic risk because they are vulnerable to failing under conditions of high volatility.

    There are good counterarguments to both of these Kaufman Report assertions, but none of these appear in your article. :-(

    Brad Hessel

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