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Blame ETFs for Lower Stock Volume?

Are ETFs contributing to the lower stock volume? It's unlikely to be a major factor. I noted Wednesday that January consolidated volume was about 18 percent lower than the same period last year. That is bad, and traders have cited the usual suspects (fear, less prop desk trading, low volatility).

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But several traders have asked if the increased popularity of Exchange Traded Funds (ETFs) — where traders and investors simply buy an ETF linked to an index — might also be responsible for the lighter volume.

This seems unlikely. There is no difference in the dollar volume between buying stocks and an ETF. If someone decides they want to put $1 million to work in stocks, and instead of, say, buying $1 million of IBM stock, they buy $1 million of the S&P 500 ETF, that volume in SPY still shows up on the consolidated tape.

In fact, the opposite may be true. Robert Arnott of Research Affiliates wrote to me that "many ETFs are used by hedge funds for high-volume trading of their own, so ETFs generate much higher trading volume than conventional mutual fund index funds."

Finally, a question I have been often asked: don't market makers have to buy and sellthe underlying stocks every timean ETF tied to an index is traded?

No. Most ETF trades do not have to be tied to the purchase or sale of the underlying securities. As Paul Justice of Morningstar noted to me: "The beauty of the ETF is that when you buy it, you have ownership rights of the underlying shares." None of the underlying shares have to be traded on the open market until an Authorized Participant creates or redeems shares; the ETF shares can trade and you have implicit ownership of the underlying stocks.

This is a bit different than a mutual fund. If I buy shares in a mutual fund, the fund manager has to buy shares in the open market, and sell shares when I sell. See the difference?

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