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Do ETF Flows Move the Market?

As exchange-traded fund (ETF) flows have grown over the past few years, the question of whether those fund flows influence the prices of ETF holdings has become a perennial issue. Matt Jarzemsky and Chris Dieterich of the Wall Street Journal recently posted what is perhaps the highest profile discussion of this issue to date, in which they provide interesting evidence that the ETF 'tail' might be wagging the market 'dog.'

They note that in early October, mid-cap indexes saw uncharacteristically poor returns relative to large- and small-cap indexes. According to the article, "it was just the fifth session in the past five years when the S&P's large- and small-cap indexes have risen while the midcap benchmark fell, according to FactSet. The last time that occurred was Jan. 20." Interestingly, the losses in the mid-cap indexes seemed to track two large ETFs who "sold off on heavy volume throughout the day, with each setting a record for the number of shares traded in one session."

This question has been hotly debated in the world of futures-based ETFs, especially volatility-linked products. In those markets, the volume of futures contracts 'rolled' each day by the ETF can amount to a large percentage of the total volume in the futures market. There has been vigorous debate about whether there in fact is a pricing effect or if traders can front-run those purchases and sales and thus distort market prices. Some sources have suggested position limits in those futures markets to prevent ETF flows from having too large an effect.

However, such market distortions are difficult to prove conclusively. ETFs provide a creation and redemption process that allows certain dealers the ability to arbitrage away any discrepancy between the ETF and the value of its underlying assets, meaning the value of ETF shares should quickly counteract any tracking error if markets are working normally. It's also not clear what exactly caused the sell-off in the two mid-cap ETFs mentioned in the WSJ story -- the iShares S&P 400 MidCap Index Fund (IJH) and the ProShares Ultra MidCap 400 (MVV).

So while the exact price impact of ETF fund flows on their underlying assets remains undetermined, it is clear that ETFs have become a dominating force in many markets, and that further pricing anomalies will be closely watched by analysts and market participants.