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Tickers in this Article: IJH, MDY, XOM, CREE, SPY, IVV
This investing business is a funny game. Not that long ago, "institutional ownership" was a tacit stamp of approval - a hint that the company had passed the rigorous test of the professionals. Now, in the shadow of the June 22 "flash crash" - for which ETFs took at least some of the blame - one has to wonder if heavy institutional ownership is a liability via the volatility that it can bring about.

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I'll admit I initially scoffed at the idea, figuring it was a case of sour grapes. I reasoned that investors just wanted to transfer the blame for their losses to a rigged system, or overzealous program trading that caused so many of the stocks in an ETF to be sold en masse, thus jump-starting a chain reaction sell-off.

Flawed Theory

There's a key problem with that theory, though. A steep decline in an ETF's value (or even a deep dip in the values of the underlying stocks) doesn't prompt any selling of an ETF portfolio's stocks. The portfolio itself may lose value, but ETFs aren't "redeemed" for cash like a traditional mutual fund would be (a lot of fund redemptions could indeed spark such a sell-off). When you sell an ETF, you're selling the same basket - in whole - to another investor; the portfolio itself is unaffected.

In other words, sorry, but ETFs aren't the culprit - or are they? (To learn more about ETFs, see Special Feature: Exchange-Traded Funds.)

The Actual Problem

Though this theory has been suggested less frequently, I suspect it might actually be the root of any volatility problems that have indeed been created by the ETF industry.

What's the theory? Some - not all, but some - stocks have been hijacked by well-intentioned ETF sponsors. As a result, these equities may well be subject to considerably more volatility simply because their float isn't effectively as big as the numbers suggest.

Let's Illustrate With Examples

We'll use the world's biggest ETF as a starting point - the SPDR S&P 500 Fund (NYSE: SPY). This fund holds a whopping $80 billion worth of securities. The biggest piece of the pie is ExxonMobil (NYSE: XOM), making up 3.17% - over $2 billion - of the fund's total portfolio. No big deal, as Exxon's market cap is a massive $310 billion; SPY only holds less than 1% of the total number of XOM shares.

But what happens when you start dissecting some of the more obscure and smaller ETFs? The problems become a little hairier.

Take the SPDR MidCap S&P 400 Fund (NYSE: MDY), for instance. A mere 0.8% of this $9.8 billion fund - about $70 million - is allocated to Cree (Nasdaq: CREE). The thing is, with a market cap of only $5.5 billion, that's over 1% of the total company.

Now, while those calculations should prompt questions, they aren't show-stoppers. There's more to the story.

Even Worse

ExxonMobil? Yeah, the S&P 500 SPDR fund owns about 1% of the company. A competing large cap ETF - the iShares S&P 500 Index Fund (NYSE: IVV) - also owns about 0.22% of XOM. That's still not to the point of sounding an alarm, but how many different ETFs own ExxonMobil? Energy funds also own it, some blue chip funds and the DJIA own it, and some style funds may own it. When it's all said and done, a much bigger chunk of the company may be in fund companies' hands than we could ever realize.

The same goes for Cree. The SPDR MidCap S&P 400 Fund owns about 1% of the company, but the iShares S&P MidCap 400 Index (NYSE: IJH) owns another 0.8% of CREE. The stock can be found in plenty of other ETFs, too - tech, mid cap, style, etc.

The Institutions Aren't Selling

The problem here isn't that so much of a company is held by funds, though - it's that these institutions aren't letting go of any of those shares.

See, as I said above, with an ETF, once a portfolio is built, it's pretty much built; the fund sponsors aren't putting those shares back into circulation except on their terms. Smaller effective float? Same investor trading interest? No wonder things are getting volatile.

And yes, the penchant for new, obscure and niche ETFs is exacerbating the problem the further you go down the size scale. Institutions are clogging liquidity.

Maybe Less Is More

It's not a complaint - just a reality we all need to start accepting and responding to. Maybe a little less niche marketability or institutional interest (or perhaps not being in an index) can be a good thing.

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