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Renewed Warnings about ETFs: Volatility Baked into the Cake?

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The popularity of exchange-traded funds keeps rising. By some estimates, ETF assets are projected to soar past $15 trillion by 2025 as big industry players like BlackRock, Invesco and State Street continue to build their pipelines and create new funds.

The Wall Street Journal, however, has warned in an article that during down markets "ETFs could make things even worse."Markets reporter Simon Constable pointed to research that indicated "the proliferation of exchange-traded funds could create problems in a volatile market."

As we've noted in the past, it's important to realize that ETFs are designed as trading vehicles. Increased numbers flooding the U.S. marketplace in past years continues to raise concerns, according to the paper, about how big institutional traders and brokerages are creating liquidity and value on a daily basis for these types of funds.

"In short, while ETF market makers are required to own the shares that make up the basket of stocks the funds represent, rules allow them to sell shares that they don't already own, similar to so-called shorting, on the presumption that they will purchase those shares later," Constable wrote. "Settlement of these trades, however, does not always happen quickly."

When market volatility is particularly turbulent, some analysts have complained so much "operational" shorting activity takes place that "the number of shares of certain stocks reflected in the total volume of these trades can exceed the number of shares that actually exist," according to the WSJ article.

In particular, Constable cites an in-depth study of such issues by four academics.2 A co-author of that research piece, finance professor Rabih Moussawi of Villanova University, explains it this way: "The reason there is more risk is that the ETF market makers can transact among each other and those trades aren't required to be settled immediately." 

Although the report covered a specific 12-plus year period (through 2016), IFA's investment committee still considers its general insights as useful these days to investors as they broadly consider basic constructs of asset-allocation strategies involving ETFs and mutual funds.

Of note, this study uncovered a general tendency over varying periods of relatively high levels of operational shorting. It used regression analysis and compared ETF activities with trading in common stock shares over an extended timeframe. Researchers found that in 2016 alone, 78% of all failure-to-deliver (FTD) instances in U.S. securities markets came from ETF-related transactions. That was up from 72% a year earlier, the paper adds.

In this regard, FTDs are described as "electronic IOUs" where a market participant who has "engaged" in a short-sale doesn't deliver the underlying security at the time of settlement. In the U.S., this period is characterized as normally taking up to two days after the transaction date, and referred to as "T 2" by securities trading professionals.

The graph below shows data collected by these researchers comparing rolling-average daily dollar values of what they characterized as "operational" shorting activities and FTDs for ETFs during a nearly 13-year period. Since it covers a select period, the main takeaway for long-term investors isn't any exact data point. In our view, this study remains noteworthy for raising technical concerns about the proliferation of ETFs by uncovering past patterns in which increased shorting transactions led to greater failure-to-deliver instances -- and dollars lost by investors -- in these types of funds.

Fig1_Operational Shorting and Failure to Deliver Activity of ETFs

The big picture issue from a more strategic point-of-view for investors trying to decide between ETFs and mutual funds is uniquely raised in this paper by its cautioning message that overall growth in the volume of FTDs can lead in certain conditions to increased trading risks with ETFs. That's in terms of impairing some "market participants' ability to meet their other obligations in a timely way, leading to greater counterparty risk," the authors report. 

This isn't the only piece of noteworthy research to question whether trading in ETFs can increase risks for investors when market conditions are in flux. Separately, a study ("ETFs Track Liquidity Risk on top of Asset Performance") published by Moody's Investors Service in mid-2019 noted periods in which banks refrained from providing market liquidity for certain bond ETFs. As a result, under such conditions trading in these types of funds became more expensive and volatile for investors.

"We're looking at a changing environment where the traditional banks that acted as market makers have stepped away from the scene," Fadi Abdel Massih, a Moody's analyst who authored the report, told Institutional Investor in reviewing his research team's findings.

Of course, such a lack of institutional liquidity and support for bond ETFs could turn out to be a relatively transitory development. The way these funds are structured and traded on a daily basis, however, is credited by Moody's researchers as lending credence to their heightened view that investors would be well-served to tread cautiously with bond ETFs amid any severe market downturn. 

"In effect, ETFs track not only the performance of their underlying assets, but also the liquidity of these assets," Moody's study related. "Therefore ETFs targeting illiquid instruments, such as corporate bonds and leveraged loans, would present greater risks, and investors trading on the premise that ETFs are more liquid than their baskets may find that results fall short of expectations in a stressed environment."

Such fairly comprehensive research projects are part of a body of independent and objective evidence that we find significant to support IFA's view that ETFs are best served as placeholders -- or alternatives -- when traditional passively managed mutual fund options are limited in a particular asset class or global marketplace.

While our research team continues to monitor leading ETFs with high levels of liquidity, we prefer traditional mutual funds that are designed for long-term investing, not short-term trading. The operational differences, borne out by our own real-life experiences in working with clients, underscore how important it is to choose not only the best designed index, but also the most risk-appropriate open-end mutual fund.


1.) Wall Street Journal, "In a down Market, ETFs Could Make Things Worse," March 3, 2019. 

2.) Rabih Moussawi (Villanova University), Richard B. Evans (University of Virginia), Michael Pagano (Villanova University) and John Sedunov (Villanova University), "ETF Short Interest and Failures-to-Deliver: Naked Short-Selling or Operational Shorting?" April 2019. 

3.) Moodys' Investors Service, Fadi Abdel Massih,"ETFs Track Liquidity Risk on top of Asset Performance," May 2019.

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