Many ETFs (Exchange Traded Funds) Now At Risk

The stock market’s coming ailments I recently discussed (shakeout and washout) will once again find the SEC’s electronic trading protections lacking. Computerized “circuit breakers” remain weak substitutes for the human specialists they replaced. “Flash crashes” (where electronic bids plummet or disappear) remain a possibility, and that’s where the problems with many ETFs come in.

The problems with ETFs

Mention “ETF” and investors think of the big index funds. Those are fine. However, below the popular, established and straightforward ETFs are hundreds of small, specialized ETFs. Differentiation from other ETFs is viewed as the way to create demand. It has been achieved by reshaping or narrowing down an established index, by creating a new index, or by doctoring up a typical long position index with leverage, derivatives or short (“inverse”) positions.

The hope is that investors will find the specialty funds beneficial. However, (and this is the key problem) such specialty expansion crosses into the professional area. The use of uncommon and unique indexes along with complex investing strategies requires expertise to understand the new funds’ return/risk characteristics. Otherwise, there is the possibility (probability) that “average” investor will be misled – even enticed – through lack of understanding.

ETF creation looks to be in the final stage

The characteristics of many, newer ETFs are strange, skewed contrivances. For example, check out these recently introduced beauties:

• Tidal Trust II – Nicholas Fixed Income Alternative ETF
• Innovator Gradient Tactical Rotation Strategy ETF
• Dimensional Emerging Markets Sustainability Core 1 ETF
• AllianzIM U.S. Large Cap Buffer10 Nov ETF
• BrandywineGLOBAL Dynamic U.S. Large Cap Value ETF
• FT CBOE Vest Rising Dividend Achievers Target Income ETF

Can you guess what any of these ETFs do? No? Should you spend time researching them? No. They’re simply irrelevant encores to an overlong play that’s over.

Oh, there may be some remaining, mini-niche investing need crying for an ETF to fulfill it – but probably not.The ETF factories have already scoured the landscape. Instead, recent “handcrafted tools for advisers and investors” simply look like hail-Mary passes as time runs out for the specialty ETF game.

Some ETF creators are engaged now in the old fad-ending desperation of throwing spaghetti at the wall, hoping something will stick to keep the game going and fees growing. But reality is bearing down, and that means time is running out for many funds in the 3,000+ ETF fund industry.

Want more proof? Look at the latest nonsensical contrivances: individual stock ETFs. “What! One stock funds?” I know! And yet there are multiple ETFs recently created for “popular” stocks like Tesla. Why? There is only one viable reason: It’s a new (albeit, pointless) way to layer on a fee. The “funds” are just simplistic packages of what investors can do for themselves – and better. For example, the seven (!) Tesla ETFs fall into three categories that investors can replicate for themselves:

1. “Multiplier” – Buy Tesla stock in a margin account
2. “Inverse” – Short Tesla stock
3. “Income” – Write call option on Tesla stock holding

A major risk accompanies all these ETF creations: Weak liquidity

The daily charts of these new ETFs reveal the kiss of death in the stock market: Followers are few, so trading is spotty. That, in turn, means the bid-ask spread for selling and buying is too big in normal times. (Remember that the ETF design to keep market prices close to their net asset values depends on professional traders sitting at the ready to help fill orders through their own strategies designed to earn a bit and not lose. Low trading volume complicates that task.)

Then there are the abnormal times, particularly when many investors decide to sell. As already demonstrated in past rocky stock markets, pricing/trading problems arise in lightly used ETFs. With little natural trading volume, an investor’s sell order in a declining market could be filled at a poor (below net asset value) price. In other words, the ETFs could harm investors in rocky markets, even as do-it-yourself strategies are easily unwound or adjusted at fair prices.

One final risk: Misleading investors

Back to those crazy names above. They, and the many others like them, should be available only to professional investors and advisers. The funds are complex, so they fall into the camp of potentially misleading non-professional investors.

There is worse, though: Catchy names and presentations that misrepresent a fund’s returns and risks. They are designed to snare “average” investors, and that’s a big SEC no-no. An example is the recent batch of single stock “YieldMax” ETFs with “Option Income” in the titles. For the Tesla ETF, “YieldMax TSLA Option Income Strategy ETF,” the implied income focus is fleshed out in this Investment Objective: (underlining is mine)

The Fund’s primary investment objective is to seek current income. The Fund’s secondary investment objective is to seek exposure to the share price of the common stock of Tesla, Inc. (“TSLA”), subject to a limit on potential investment gains.

Add to that this current, December 19 press release, “YieldMax Launches Two New ETFs Designed to Deliver Attractive Yields.” The first five paragraphs are all about income and yield.

So, imagine investors’ surprise and disappointment when their new ETF holding fell almost 13% in the first 3-1/2 weeks of its existence. (No income payments have been made yet.) Then, there is that obvious lack of trading liquidity, with only paltry trading during the 18-day period. Eight days had zero shares traded. The chart shows the inaction.

So, how likely is it that the stock market will run into a serious problem?

The stock market has elements that make a dual shakeout-and-washout affair look probable, and perhaps soon. If and when the stock market endures its dramatic makeover, the fund management firms once again will pull out their tune-up manuals. The result? Their fund lineups will be reworked. Out will go the proven money losers, along with the non-growing ETFs that are viewed as unnecessary and time wasters. (A corollary housecleaning will be the support staff for the then shrunken fund lineups.) Here is the current ETF data that reveals the potentially large ETF shrinkage that could occur…

The number, size and trading volume

From the “NYSE Arca Q3 2022 Quarterly ETF Report“:

• 3,030 ETFs listed in the U.S.
• $ 5.9 T assets in U.S. markets
• $ 149 B average daily value of U.S. ETF transactions
• 2.3 B average daily volume of share traded

The large number of mini-sized ETFs

(Source: VettaFi – formerly ETF Database – ETFDB.com – 3,018 ETFs in the database)

• 2,445 ETFs (81%) with less than $1M in assets
• 2,197 ETFs (73%) with less than $500K
• 1,925 ETFs (64%) with less than $250K
• 1,470 ETFs (49%) with less than $100K

Additional information:

• 1,215 ETFs (40%) have had net outflows in 2022

The large number of weak performing ETFs

(Source: Financial Visualizations – FinViz.com)

• 2,142 ETFs in the database
• 696 ETFs (32%) with YTD 2022 performance worse than -20%
• 932 ETFs (44%) more than 20% below 52-week highs
• 1,003 ETFs (47%) with average trading volume less than 50K shares

Sporadic and low trading volume is a weakness. As an example, on Friday (Dec. 16), 1,088 ETFs (51%) had volume less than 50K, of which 532 (25%) had less than 10K.

The bottom line – Choose your ETF wisely

ETFs are fine for well understood index funds. They are low cost and available for buying and selling throughout the day at a price that is very close to the fund’s net asset value per share. (The exchange traded fund structure was created to provide intraday trading like closed-end funds, but without the drawback of prices being at discounts or premiums relative to the fund’s true value.)

The problem is applying the structure to anything and everything that trades. Those non-worthwhile creations serve little or no purpose and can even trip up rather than help investors. The latest concoctions clearly are not winners, so the time is ripe for a messy cleanup to occur. Do not get caught in it.