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.
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.
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