Here’s a one-question quiz on the recent market correction:
Which of the following was NOT a cause of the correction?
A) Investor concerns about higher interest rates.
B) Investor concerns about rising wages.
D) A and B – but not C. Well, a little, tiny, very narrow bit of C.
In the painful days since the correction, I’ve been asked many times about the role of ETFs (exchange-traded funds) in triggering that painful event, and whether ETFs should still be considered for private investor portfolios. The answer to the second question is yes. ETFs are a legitimate, mainstream investment vehicle that individual investors should consider holding as part of their overall strategy.
Now let’s talk about how ETFs contributed to the correction. The bottom line is that the collapse and near-collapse of a very small group of unique ETFs did help light the correction fuse.
An ETF is a basket of assets – stocks, bonds, indexes, commodities, et cetera. In this regard, ETFs are similar to mutual funds. But unlike mutual funds, an ETF trades like a common stock on an exchange. ETF prices change throughout the day as investors buy and sell them. And ETFs typically have higher daily liquidity and lower fees than mutual fund shares, making them an attractive alternative for individual investors.
The ETFs that contributed to the correction traded in a very esoteric thing – market volatility, as tracked by such measures as the Chicago Board of Options Exchange’s VIX. These ETFs allowed sophisticated traders a way to bet against rising market volatility. As the market grew more and more placid over the past two years, investors poured tens of billions of dollars into these ETFs to short sell volatility.
These ETFs went up and up, as volatility went down and down. But because we were long overdue for a correction, traders were always ready to bail out at the first sign of a pullback.
That’s exactly what they did earlier this month. When the correction began, the VIX index went up dramatically, from 9 to almost 40. The ETFs that bet against it just collapsed. Some even went to zero. The result was a disaster for owners of those ETFs, most of whom, I suspect, were professional traders, not individual investors and retirees.
So, the answer to our quiz is “D.” ETFs, in general, were not a cause of the recent correction. ETFs are simply another asset option for investors, one that you might consider for your portfolio – so long as they trade in something you understand and fit within your personal risk tolerance.