The ETF-ization of everything

• abnormalreturns
• June 9th, 2010

“Once you measure something, it changes.”  – a variation on Goodhart’s law (see also Cory Doctorow)

This point is illustrated nicely in a post today by Howard Simons at Minyanville.com.  In it he examines how the behavior of standard corporate indices changed after the introduction of an investment grade corporate bond ETFs:  the iShares iBoxx $ Invest Grade Corp Bond (LQD).  Simons writes:

Indexation of any kind changes the behavior of investment managers who inevitably get their performance measured against an index. What’s worse is how even the most arbitrarily assembled index, one which might be important only to its creator and to anyone who has a vested interest in volume therefor, suddenly is elevated to exalted status by participants at all levels. Even the broadest and most senior indices change behavior; you’ll find individual investors fretting they’re underperforming the S&P 500 and not have an inkling as to why they should care.

The same could be said of the commodities market as well.  In a recent post we discussed how accelerated demand changed the underlying dynamics of the commodities futures market thereby eliminating the very characteristics investors demanded.

The point is that markets are not immutable things.  They change.  On the supply side as indices (and ETFs) get created herding behavior tends to push managers towards tracking these highly visible vehicles.  On the demand side as an asset class gets commoditized into an easily tradeable form it becomes easier for a new class of investors to enter.  Thereby changing the market dynamics.

It is easy to see why ETF providers do this.  It is good for business.  Easy access to ETFs can make the implementation of many strategies easier.  The challenge for investors is knowing whether, as Simons notes, the index they are following or investing in is well-constructed or quite arbitrary.  Which makes knowing what they own all the more important for the wise investor.

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