Will ETFs Destroy the Stock Market?

Now more than ever, investors are turning to exchange-traded funds to tailor their investing exposure in precise ways. But by doing so, are investors actually sowing the seeds of their own destruction?

Some analysts are convinced that the answer is yes. By shifting a huge portion of trading volume toward rote index-based strategies, they argue, ETFs have made the stock market a much more dangerous place to invest -- and have removed one of the basic staples of safety in investing.

Rage against the ETF machine
Last week, Congressional hearings tackled the topic of exchange-traded funds. Among the ideas discussed was the possibility of segregating "dangerous" funds like leveraged and inverse ETFs into a separate category from "safer" ETFs that don't use derivatives or other unusual trading strategies.

But as Reuters contributor Felix Salmon pointed out yesterday, even "regular" ETFs contribute to a major problem for investors. When everyone piles into particular ETFs, then the trading in those ETFs leads to huge demand for the stocks that are components of the indexes the ETFs track. That in itself can be a problem if that demand is artificial and doesn't reflect the underlying fundamentals of the stocks the ETFs buy and sell.

Even worse, though, trading through ETFs can jeopardize the value of diversification. After all, if ETF-related trading in component stocks dwarfs the volume that individual-stock investors create when they buy and sell those stocks, then the stocks will increasingly move in lockstep with the ETF -- and cross-correlations among individual stocks will drop precipitously. That means that in a market crash, all the stocks in a given ETF will feel the same downward pressure.

Opportunity from indexing
All of that is bad news for investors who solely want to use ETFs in their portfolios. On the other hand, if you're willing to trade individual stocks, all the money trapped in well-defined, transparent ETF investing strategies opens doors to profit opportunities.

One well-known strategy that predates ETFs involves buying stocks immediately before popular indexes add them to their constituent lists. For instance, last week, S&P announced that TE Connectivity (NYS: TEL) would replace Cephalon, which Teva Pharmaceutical (NAS: TEVA) had acquired. TE shares jumped more than 5% in the two trading sessions between the announcement and the day on which the addition became effective. Similarly, back in June, Marathon Petroleum (NYS: MPC) jumped 11% after its spinoff from Marathon Oil (NYS: MRO) allowed the refiner to become eligible for S&P 500 status.

More broadly, research shows that additions to the S&P 500 and Russell 2000 indexes have produced gains of almost 9% and 5% respectively, with companies being taken out falling 15% and 5% in the days leading up to the index moves. Although moves are relatively infrequent, they add up to drags of around a quarter to three-quarters of a percentage point annually for those indexes.

Avoiding bad stocks
The flip side of the coin is that sometimes, you'll get stuck with stocks in an ETF that you don't particularly want. You shouldn't be afraid to take individual positions selling those stocks short to offset the shares you own indirectly through your ETF holdings.

As an example, say you wanted to invest in energy stocks but thought that smaller companies like Spectra Energy (NYS: SE) and Williams Companies (NYS: WMB) had better prospects than the two oil giants that dominate the ETF's assets: ExxonMobil and Chevron (NYS: CVX) . In that case, you could buy shares of the ETF but sell an equivalent number of Exxon and Chevron shares short. That would still be simpler than buying individual positions in all 40 of the other stocks in the ETF, but it would give you the exposure you want -- and if smaller energy stocks beat Exxon's and Chevron's returns, you would profit from the move.

Be smart about ETFs
Exchange-traded funds are a great way to simplify your investing, but they do have limitations. Fortunately, you can exploit those limitations to your advantage -- if you know about them and are willing to do the extra work it takes to find the profit opportunities they create.

One smart way to use ETFs is by considering which sectors will benefit most in the current economic climate. Find out about three ETFs that are poised to rise in a recovery in a special free report from The Motley Fool.

At the time thisarticle was published Fool contributor Dan Caplinger knows all tools can be bad or good depending on who uses them. You can follow him on Twitter here. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Teva Pharmaceutical. Motley Fool newsletter services have recommended buying shares of Chevron, Teva Pharmaceutical, and Spectra Energy. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy is constructive, not destructive.

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