ETF Aha! Moment

ETF Aha! Moment

I was reading a discussion about the markets this weekend and came across this fascinating passage:

Another disruptive factor to price discovery has been the proliferation of exchange-traded funds (ETFs). Accounting for more than 30 percent of trading volume in the markets, some ETFs are influencing the markets they track and impacting their underlying holdings. A study by Goldman Sachs confirmed that ETF trades influence stock prices. The study looked at which individual stocks move more with the dynamics of the ETF than on their own fundamentals and found that those stocks most affected by ETF activity are in the Russell 2000, probably because of their lower levels of liquidity, lower volume and cheap prices.

Now just think about that for a second.  ETFs were created to mimic a basket of stocks.  But ETFs have proliferated so much, that some stocks are beginning to mimic the ETF that they are part of! The proverbial tail wagging the dog.

So when stocks move more with the ETF than their fundamentals, you get more stocks that are mispriced,  both too high and too low.  When a stock is priced incorrectly, that creates opportunities for investors and frankly for acquirers of businesses, either Private Equity, LBOs or competitors.

Of course the stocks potentially impacted by this are the opposite of what I have been thinking about - 750m or greater market caps with a decent dividend. Hmm, consider me corrected.  The median stock in R2K is 697m and the largest is $6.7b.  I do though think it is safe to expect that the smaller stocks in R2K would be the most impacted by the ETF.

Fascinating.