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THE ETF PHENOMENON

It can be argued that the emergence and growth of Exchange Traded Funds (ETFs) has been a huge boon for investors. We won¡¯t weigh in on that here.

However, the phenomenon does have several by-products of considerable note. First, commensurate with said growth has been the ascension of program trading as the dominant force in the market, often now accounting for 60% or more of total daily volume on the NYSE. Second, mutual fund portfolios are looking increasingly similar. Most are structured to behave like the benchmark Index.

ETFs (Exchange Traded Funds) are more and more being used as market surrogates and hedges. When everyone owns the same thing and acts the same way, what is referred to as herding (in behavioral finance) controls the market. This is a term used to describe situations in which a group of individuals react similarly without there being any co-ordination between them. The term is used to describe the behavior of animals within herds and flocks, and to describe certain kinds of phenomena such as stock market bubbles and the resultant fallout from same. Herding tends to inflate valuation; buyers begetting buyers begetting buyers raises the price beyond what would be deemed reasonable and fair. [A recent Wall Street Journal article documented that the price of silver has jumped roughly 28% since the SEC sought public comment on the proposed first-ever silver ETF in January of this year. Barclays, the issuer, has applied to list 13 million shares of the new silver ETF backed by 130 million ounces of silver. The investment bank Salomon Partners has estimated that these 130 million ounces of silver equates to about 16% of the world's annual silver production and 21% of the known above ground inventories.]

The concern with all ETFs is that should the day come when market participants all want to leave at the same time, that the move to the exits will not be an orderly one.

The 2001-05 compound annual rate of growth for our stocks simulation is 42.2% whereas the S&P 500 had negative growth for the period. Through Sep 2006, performance was a gain of 13.3%. Learn more here.

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