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Are ETFs Behind the Market’s Shrinking Volume?

Since 2009, trading volume has withered as ETFs have exploded. Is this where all the money is going?

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Past the Tipping Point?

The potential problem is no longer a concept, but a reality: The effective, liquid float — and perhaps more important,  any real reason for investors to need or want individual stocks — is starting to shrink. Traders aren’t looking to buy XLE and CVX; they’re looking to buy XLE or CVX. And increasingly, they’re opting for the fund over the stock.

It’s not like these fund managers are likely to let go of these stocks and put them back into the open market anytime soon, either. Indeed, their percentage of individual stock ownership is only apt to increase as time moves on, based on history.

Though not to the same degree as mutual funds, which buy and sell stocks every day in accordance with investors’ buying and selling of the fund, exchange-traded funds do build (and occasionally redeem) so-called creation units on a fairly regular basis, as demand merits. “Creation units” are just big, and identical, blocks of stocks that act as an ETF’s underlying assets. While most retail investors never see them or know about them, the ability to expand a fund by increasing the number of creation units allows ETF sponsors to accept “new” money on an ongoing basis.

And they have.

In 2011, a little more than $100 billion of new cash went into new – and existing — ETFs, which is on pace with “new money” levels poured into the ETF industry in 2010, and even 2009. That brings the total amount of ETF-managed assets to a little over $1 trillion. Though some of the funds’ holdings are foreign stocks, the bulk of them are U.S. names. And the U.S. is the biggest single source of ETF demand.

Compared to the total $17.21 trillion market cap of U.S. listed stocks, it doesn’t seem like much. Keep in mind, however (and as was said already), ETF sponsors generally don’t let go of any stocks once their fund owns them, because there’s little need to sell shares. Even the institutions see little reason in redeeming ETF shares in exchange for the underlying stocks. So, while it’s not impossible to think the underlying stocks held by funds could be released, odds are good those holdings are — for the most part — locked up.

Here’s the thing: It wasn’t just a January phenomenon. Cash displacement from stocks to funds has been a problem for a while.

Despite forward progress during some of the time between then and now, the market’s overall volume started to noticeably dwindle in March of 2009. It was the first time in decades volume started to slump for any reason, but to see volume dry up during a rally? That’s a major red flag.

Although it’s not the only possible reason for fading volume from one month to the next since early 2009, the volume decline suspiciously jibes with the heaviest/fastest phase of ETF creation yet. If it’s just a coincidence, it’s a major one.


The explosion of ETFs still doesn’t fully answer the question “Where did all the money go?” (see Part 2 for the rest of the answer). But the growth of the ETF industry may mean there’s at least a little less cash on the sidelines right now than we’d all like to hope. If you’re counting on a sudden inflow to make for a bullish 2012, it may not happen, at least to the degree you’re expecting.

Don’t throw in the whole towel just yet though because there’s more to this story. . .

As of this writing, James Brumley doesn’t own any of the securities mentioned here.

Article printed from InvestorPlace Media,

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