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Are ETFs Vulnerable in Periods of Sharp Market Volatility?

This article was originally published on ETFTrends.com.

Societe Generale SA warned of potential liquidity risks in some ETF segments, notably those that track less liquid or smaller market categories.

After stress-testing 16,000 stocks, the French bank argued that small-caps, dividend stocks and gold miners are acutely vulnerable in market pullbacks due to the outsized ownership of passive investments due to the lockstep nature of these types of investments, Bloomberg reports.

“Crowdedness exists but is limited to a few stocks and strategies,” SocGen analysts led by Sebastien Lemaire wrote in a report last week.

The analysts warned that these positions could prove more costly for investors to exit once volatility spikes and many traders start to head toward the same exit. The conclusion is among the critiques ETF naysayers have pointed to, arguing that passive money has fueled an investing-herd mentality or contributed to crowding risk.

BlackRock, the largest ETF issuer through its iShares brand, has dismissed these warnings as fear mongering.

“This research is underpinned by two assumptions that don’t reflect the historic behavior of investors or ETFs,” the firm told Bloomberg. “To assume that all investors behave the same way in times of market stress is not grounded in reality. Additionally, we have repeatedly seen ETF volumes grow dramatically during times of stress as investors utilize them as a tool for price discovery.”

For instance, BlackRock pointed to its Turkey ETF, iShares MSCI Turkey ETF (TUR) , as a recent example. The ETF's underlying index plunged 16% on August 10 but trading remained orderly with no outsized impact on underlying shares.

“TUR saw its highest amount of daily trading volume ever, with 13.3 million shares exchanging hands that day, compared to its previous average daily volume of 500K shares,” BlackRock said.

Societe Generale's findings on ETF liquidity issues are not all negative. The bank found that around 90% of the world's equities aren't likely subject to a liquidity squeeze since less than 10% of the company stocks are owned by ETFs.

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