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Proof: ETFs a Self-Fulfilling Prophecy

From the "markets-are-broken" department: Whenever we talk about the impact of exchange traded funds (ETFs) on the market, the one missing link is quantitative evidence that ETFs (especially the levered ones) are rapidly becoming the monster they weren’t created to be.

A trader holds his head in his hand on the floor of the New York Stock Exchange in New York City
Getty Images
A trader holds his head in his hand on the floor of the New York Stock Exchange in New York City

Then along comes a report from Global Hunter Securities energy analyst Michael Bodino—and there it is.

Bodino delivers the proof on the impact of levered ETFs, which are designed to goose performance by two or three times, and adds this twist: By the very nature of the way ETFs work, they create an artificial market for the stocks they own.

Therein lies the self-fulfilling prophecy, which in retrospect seems so obvious.

And then he comes right out and says what we’ve all been dancing around when trying to figure out why this market is so out of whack: “As investors wage bets and purchase levered and non-levered oil and gas ETFs, they are inadvertently longing and shorting certain stocks for no apparent fundamental reason.”

That’s right, index-based ETFs (which make up most ETFs) are agnostic about the companies they own. They’re bought and sold because they’re in the index.

That’s always been the case with index-based mutual fund, with this difference, as I’ve been pointing out to anybody who will listen: Index mutual funds, which price once a day rather than DURING the day, weren’t used by institutions to hedge (long AND short) portfolios. And they certainly weren’t juiced with derivatives and other techniques designed to create supercharged returns.

More to the point:

Bodino drilled into the cash flows of DIG and DUG , levered long and short oil-and-gas ETFs. At the same time he looked into the correlations between those ETFs and the S&P Supercomposite Oil and Gas Index.

Rather than me try to summarize what he says, I’m going to quote liberally from his report (with any emphasis in bold, by me):

"When investors purchase ETFs, they assume ownership over a basket of securities providing them with broad exposure to a particular sector, cap size, or asset class. For instance, DIG has weightings ranging from its largest holding of Exxon Mobil at 26 percent, to its smallest holding of Parker Drilling, which represents less than 1 percent of the fund. Of the 95 holdings that are contained in DIG, it is fair to say that it is improbable that all 95 holdings are worthy of being held long at a given time. Similarly, it seems unlikely that all 95 holdings should be fundamentally short at one time."

"However, when investors buy and sell long and short ETFs on the open market, they are transferring money to long and short ETFs to purchase or sell short certain securities which in turn create a self-fulfilling prophecy across the industry as the money flows move in and out of the underlying securities."

The proof from Bodino that this isn’t the way the markets used to be:

"Analyzing the impact of the net change in cash flows of DIG and DUG from 2010 to the present time illustrates that there is a positive correlation of 0.65 that has strengthened from the weak 0.02 correlation from 2009 to 2010, and the 0.28 correlation from 2008 to 2009. Focusing on the most recent pullback that began at the end of April 2011 until now, one can see that the correlation jumps to a very strong 0.95 between the net cash flows and the S&P Supercomposite Oil and Gas index."

"This further illustrates the rapid investor shift towards ETFs as investment vehicles. The overall effect of ETFs on the performance of individual equity securities and underlying indices is becoming more apparent as ETFs gain further popularity from retail and institutional investors. Money flows normally never lie, as price appreciation and depreciation are a component of the influx and reflux of money from one asset class or security to another. Prior to the ETF proliferation, the correlation with energy equities and commodities was evident but since 2007, the ETF, market and energy equity correlation has dramatically risen despite short-term oscillations in the commodity."

Bingo!

But wait, there’s more, and this is where Bodino hits the target:

"Since 2007, the performance of DIG has most closely mimicked that of the S&P Supercomposite Index with a strong positive correlation of 0.99. Surprisingly, DIG has a stronger correlation (0.99) than that of the underlying assets of oil (0.68) and natural gas (0.34), which further supports our thesis that the ETFs and the respective net money flows have begun to have a larger impact on indices and many individual companies than the underlying commodities themselves. As investors continue to pile into ETFs to gain broad exposure, risk mitigation, and liquidity, we may continue to see further exacerbation of fundamental approaches and weaker correlations between individual companies and the underlying commodities that drive respective operations."

I rest my case, your honor. (Okay, judge and jury, your turn!)

Questions? Comments? Write to HerbOnTheStreet@cnbc.com

Follow Herb on Twitter: @herbgreenberg and on Google+

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Disclaimer

  • Patti Domm

    Patti Domm is CNBC Executive Editor, News, responsible for news coverage of the markets and economy.

  • A CNBC reporter since 1990, Bob Pisani covers Wall Street from the floor of the New York Stock Exchange.

  • CNBC's Senior Personal Finance Correspondent

  • JeeYeon Park is a writer for CNBC.com. Follow her on Twitter: @JeeYeonParkCNBC

  • Rick Santelli joined CNBC Business News as an on-air editor in 1999, reporting live from the floor of the Chicago Board of Trade.

  • Senior Producer at CNBC's Breaking News Desk.