I am becoming concerned about ETFs distorting the market value of underlying securities. This is not a big issue yet, but as they become more and more popular the securities they contain will start moving in unison because of arbitrage, irregardless of their underlying value. Both price and volume will change to match the index as the components are fixed. There are several other question related to ETFs such as: how will illiquid securities react to large ETF/index moves, people can front run the arbiters in those situations, and those underlying securities will have to be purchased/sold to match the index. Has anybody here tried doing this? My real concern is the first point. Anybody else has a problem with this?
Sorry, just to clarify, the demand for the whole ETF/index will drive prices not underlying value of any single security.
it is a big problem for me already, it was much easier figuring out individual stock's buyers and sellers, now most of time i feel like i'm trading sp futures
that is a legit concern however you have to consider the individual securities and their weightings in the index - take small caps for example. There are illiquid securities in the R2k but most of them only make up a very small portion of the index. I think you need to look at the opposite side of the coin - the ETF moves in unison with the value of the underlying securities not the other way around. If one name in the index goes down then the index as a whole should also reflect this weighted movement and the ETF's price will move as a result. Any arb situation would be to keep the ETF in line with the underlying not the other way around.
Ok, I do agree with your first point. The general public however buys and sells because their co-workers, neighbors and friends did it, not because of fundamentals or technicals. Now they will rigidly move the entire index when they do it. This alters the price swings of of the individual components to that of the whole index. Traders do the same thing when trading, and though they might be more informed they still cause all components to move in unison. This could make trading and investing in individual securities unattractive as ETF volumes increase. If the large ETF get fractured into thousands of smaller ones relying on smaller indexes or more individual selection this situation should improve, the basic problem would still be present though to a much smaller degree. This is currently occurring, and as long as money is rebalanced between large indexes and the smaller ones we should be ok.
If I knew how to, I would take a sample of stocks listed on NYSE that are part of sp500 index and run a test to see how much their intraday movement is correlated to spy or sp futures for different periods, lets say 2007-2009 against 2001-2004 my feeling is that the correlation has increased during the last couple of years due to increase in the number of ETF's and computer trading and made it harder for traders like myself to make predictions on individual stocks
I guess the Kaufmann report confirms some of my concerns from year and a half ago. I'm not against all ETFs, just against large concentration of money in a single artificial index. Don't believe me? Then tell me what would happen if one of the largest components were dropped from the S&P 500 index tomorrow.