Could exchange-traded funds blow up and take the markets down with them?
A report released this week argues that ETFs are "radically changing the markets," raising the prospect of a "panic-driven market meltdown." ETFs are funds that hold all the securities in an index and themselves trade like a stock.
But the authors, Harold Bradley and Robert Litan, have considerable expertise of their own. Mr. Bradley, the foundation's chief investment officer, was formerly head trader and a senior portfolio manager at the American Century funds. He helped introduce the first stock-index futures contract in 1982 and was a pioneer of electronic trading. Mr. Litan, head of research at the foundation, has worked at the prestigious Brookings Institution and is a widely respected economist.
The proliferation of ETFs, the report contends, raises at least three worries. First, these funds have overconcentrated the ownership of thinly traded stocks. Second, they have led to an escalating number of trading failures. Third, ETFs could trigger another massive market swing like the May 6 "flash crash."
Let's start with concentration. According to the report, a single ETF, the iShares Russell 2000 Index Fund, is among the 10 largest holders of 1,737 stocks—many of which also are held by other iShares ETFs.