There is no such thing as a free lunch. Or free trading in exchange-traded funds. Commission-free ETF trading, the hot new way to invest, is now offered by Schwab, Fidelity, and Vanguard which have lured in billions of dollars worth of business. Other brokers like E-trade, Scottrade and T-D Ameritrade may follow suit.
ETFs are supposed to highly liquid, and are allegedly the favorite investment vehicle of day traders and small players.
But in fact the trades are not free. The ETF management groups in fact pay for trading activity. That means, in fact, that others holding the ETF incur the costs of rapid trading of these funds. But there is more.
And rapid-fire trigger happy trading of ETFs without having to pay commissions hurts markets.
As is by now well known, in the May 6 “flash crash”, when the Dow Jones fell 100 points in a few minutes after 2:30 pm close to 10%, the world of ETFs was more seriously affected. Over 68% if the trades “busted” by Nasdaq involved ETFs, starting with the biggest ETF of all, SPDR S&P 500, SPY. The situation was similar on the NYSE where 64% of the busted trades involved ETFs or Exchangte-traded notes, their close relatives These are called “questionable” or “spurious” trades but they were perfectly ordinary at the time they were booked. The only way to decide which trades are busted is linked to the amount the price fell during the crash.
So the integrity of markets is also subject to question. There is more. Thomas Petterffy, the head of Interactive Brokers, which offers $1 commissions on all trades. has testified that ETFs were the cause of the May 6 crash, not just a symptom.
And, while I cannot prove it, I think that the extreme volatility we have seen in US markets in recent weeks is linked to shot-gun ETF trading, usually in the final hour of the market day. With ever more variations of ETFs like ETNs, which also were mispriced during the May crisis, and leveraged and inverse ETFs, the risks ae higher. So too with managed ETFs which are less transpartent. Ditto for small cap ETFs, or ones investing in the bond market. The rush to replicate all the variations which exist in the closed-end and open-end fund space increases the ETF risk to the integrity of markets. Brokers (like IB) allow you to use margin to trade options on ETFs and ETNs. So the risks are even greater which is why the FINRA has been implementing new rules on margin for ETFs.
But that is only a first step.
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