One of the major changes in the stock market in the past 30 years is the development of Exchange Traded Funds or ETFs. An ETF is essentially a mutual fund that can be traded like a stock. There are ETFs that hold a single stock, and there are ETFs that hold 1000s of different names.
The first ETF was offered in January 1993 by State Street Global Advisors. The S&P 500 Trust ETF (SPY) tracks all 502 stocks that are currently in the S&P 500 index and is often referred to as Spiders. It is the largest ETF in the world, with over $370 billion in assets, and typically trades over $30 billion daily.
Currently, there are about 2000 ETFs on the market with a capitalization of around $2.5 trillion. They continue to grow in popularity, and there are new ones created almost every day.
ETFs have had a profound impact on how stocks trade. They make it extremely easy to bet on different sectors, indexes, strategies, volatility, and a large number of other market characteristics, but they also change the way that individual stocks are traded.
When you buy or sell an ETF, you are trading all the component stocks simultaneously. You trade Apple (AAPL) , Microsoft (MSFT) , Amazon (AMZN) , and all 500 other stocks in the S&P 500 when you trade SPY. This means that the merit of individual stocks is ignored. You buy and sell them all regardless of valuation or other factors.
How ETFs Can Impact Trading in One Market Sector
This past week we had a particularly good example of how ETFs can impact trading in one market sector. There are 143 regional banks in the SPDR S&P Regional Bank ETF (KRE) . KRE has been extremely active this past week as the market grapples with the bank crisis.
There are obviously a few regional banks that are still pretty good companies despite the doom and gloom in the sector. Usually, astute stock pickers will identify them and keep them from falling, but the sector is dominated by the KRE ETF. There is huge money that wants to buy and sell regional banks as a group, and that money doesn't care if there may be a few names in the group that are still quite healthy.
Because of this focus on the ETF, the entire group trades in tandem. Several times this week, every single of the 143 stocks in the Regional Bank ETF was negative. That just isn't logical. It isn't because there aren't any good bank stocks. It is because the ETF controls the entire group.
The good news is that this ETF action eventually creates some exceptional opportunities. There is substantial mispricing in many of the names that are stuck in the group, but as long as the focus is on the ETF, it won't matter.
However, over time the market is efficient. It will eventually recognize the mispricing that is occurring, and those stocks will eventually shake off the shackles of the ETF and be valued more fairly.
This mispricing cuts in the other direction also. When a sector is hot, traders will chase the ETF, dragging up many poor stocks that just happen to be part of the group. That presents a great opportunity for shorts when the ETF pressure eventually relents.
Timing Is Key
The primary problem that traders face when dealing with the mispricing created by ETFs is timing. There is no way to know when the market will start to recognize that a good stock has been trapped in a poorly acting ETF. It will require great patience, and the mispricing can go much further than seems reasonable when there are some bigger capitalization names that move the ETF.
The regional bank sector is a particularly interesting opportunity right now. There are already quite a few stocks that have been hit very hard simply because they are in the ETF. They are not in danger of going out of business and may not even have the same fundamental issues that other regional banks face. If you are willing to do some digging, there is a group opportunity in some of the individual names.
One of the oddities of ETFs is that they enhance pricing distortions within a group or sector. The more that a sector is dominated by ETF trading, then the more stocks there will be in the sector that are several mispriced. That is great news for stock pickers, but once you find the opportunities, you must work hard on accurate timing.
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