Index ETFs — The Tail Wagging The Dog
Index ETFs (Exchange Traded Funds) are a simple way to invest in the stock market. However, when index ETFs are traded on the stock exchange they can also influence the prices of the stocks that they contain.
In theory, an index ETF should exactly mirror the performance of the stock index that it is supposed to track. This is because an index ETF consists of holdings that are identical (or nearly identical) to the securities that make up the index, and in the same ratios.
Unlike a mutual fund, however, index ETFs are divided into shares that are bought and sold by traders directly on the stock market. While the trading price of an index ETF share is supposed to mirror the performance of the stock index, the day-to-day trading of index ETFs can directly affect the prices of the market as a whole.
The ability for the fluctuations of the trading price of an index ETF to influence the stock market as a whole is analogous to the metaphor of the tail wagging the dog. Since index ETFs are actually composed of stock shares, if the trading price of the index ETF goes down, this ipso facto lowers the trading price of the investments that make up the fund. Likewise, if the price per share of an ETF increases, then the price per share of the stocks that make up the fund will also increase.
An ETF's influence on the price of its component stocks can be thought of as a type of reverse causation, in which the supposed effect (the ETF price) has a causal influence on the underlying stocks. The ETF tail wagging the dog of stock prices can partially account for the wide daily swings in stock market indexes during times of investment panic. Investors unload their ETF shares during times of market unrest, unknowingly causing the market to perform even more poorly as a result.
Of course, the long-term investor is not concerned with the day-to-day fluctuations of stock market indexes, or their corresponding index ETFs. However, being aware of the causal relationships that affect market performance can help to alleviate your fears of staying invested in the stock market, since index ETFs are still perhaps the safest way to ensure consistent returns from stock market investing in the long run.
