Ask Twitter’s cohort of private investors how they feel about exchange traded funds (ETFs) and many are ambivalent. “Less fun than the crack cocaine of direct equity investments,” volunteers one. “An excuse for not doing your own research,” tweets another. ETFs may be lauded as a cheap and simple alternative to opaque actively managed funds. But one investor on the platform echoes a growing disquiet among market watchers about the rise of the ETF: it is “an accident waiting to happen”.
This fast-growing investment vehicle is rewiring investors’ interaction with the public markets, but as it has grown so have concerns about whether it is distorting market valuations and feeding volatility. Some see an ETF bubble that is set to burst, even though what is being invested in is more of an investment wrapper than an asset class in its own right.
With all the money that has rushed into ETFs over the past decade, no one quite knows what will happen when the current bull market for equities, in particular, comes to an end. Are retail investors aware of the risks to which they are exposed? How would the complicated infrastructure underlying these investments function at a time of market stress?
Choice or complexity
Let’s start from the beginning. The forerunner to today’s exchange traded fund started life in Canada in 1990, and three years later the first US equivalent began tracking the country’s major equity index, the S&P 500. The original idea was to allow investors to “buy the market” — to give them a diversified exposure to an index of stocks, so protecting them from the idiosyncratic risks of any one company going south.
Rather than trying to buy every equity in the index, the investor could buy units in one fund that would take positions in each of the constituent stocks. The advantage over traditional funds would be that the fund is traded throughout the day, with prices quoted like equities on the exchange, allowing investors quickly to enter and exit positions.
Today, ETFs give the private investor access to a wide range of asset classes and themes, from high-yield bonds and small-cap equities to the more esoteric. Two “biblically responsible” ETFs, for instance, were launched this year by Inspire Investing, aimed at companies that are seen to match conservative Christian values.
The ETF as an investment vehicle is — on the surface, at least — rather simple. “It’s very much a democratising instrument,” says Patrick Mattar, Europe head of capital markets for iShares, the ETF division of asset manager BlackRock. “It allows individual investors who might only have £5 or £10 to invest to access a wide range of exposures previously only available to much larger investors.” Most UK ETFs can be held in a retail investor’s Individual Savings Account (Isa), self-invested personal pension, or share dealing account.
US asset managers such as iShares and Vanguard, the two largest issuers, have traditionally offered “physical” ETFs — funds backed by the underlying securities that make up the index. These are distinct from “synthetic” ETFs, which are backed by a swap agreement between the provider and a counterparty such as an investment bank, which provides the index-hugging return.
Investment commentators such as Professor John Kay have warned retail investors to be “wary” of synthetic ETFs, and stick to the more straightforward physical variety. In particular, Prof Kay advocates those physical funds tracking the largest, most liquid underlying markets such as the S&P 500. “It’s hard to see how that goes wrong given that, in the end, you have a claim against the underlying securities,” says the FT columnist.
Most ETFs in Europe are so-called “Ucits” products, so fall under the same regulatory rules as their fund cousins, providing some security in the segregation of underlying assets, says Mark Fitzgerald, head of equity product management at Vanguard. “If anything were to happen to us, the owner of one of our products has a direct legal ownership right on those underlying shares which are held at the custodian.”
Too big for their boots
Adherents of ETFs present them as low cost and simple to understand. Cheap, passively invested strategies have thrived as regulatory and competitive pressures have come to bear on investment fees — and ETFs have been a major beneficiary.
The market is growing very quickly. Global ETF assets have risen from $800bn 10 years ago to $4.2tn (£3.2tn) at the end of August, according to industry data provider ETFGI. When the dotcom bubble burst, ETFs were still the new kids on the block and even by the time of the financial crisis they were nowhere near their current scale. But some believe they have yet to be tested as a model. The end of the current bull market will partly play out through ETFs, and there is uncertainty about how they will withstand sudden shocks.
Is the rise of passive management also inflating asset prices? Years of large net inflows into indexed-tracking products has encouraged a momentum effect. “Winners keep on winning and losers keep on losing,” as FT columnist John Authers has put it. Whereas active managers might buy or sell equities based on fundamental factors such as value, much passive money is effectively “blind” in that it buys assets according to the rules of the index or theme.
Markus Stadlmann, chief investment officer of Lloyds Private Bank, agrees that this automatic buying activity is a problem. “[It’s] obviously wrong because it takes the valuation of the companies to a level that is not appropriate, and it also opens up the stocks to arbitrage.”
Steven Bregman, the co-founder of US-based investment adviser Horizon Kinetics, is critical of the distortions being created by the rise of ETFs. “There is a law of supply and demand, and if something gets overdone, and too much money flows into one place, you get distortions,” he says. “This particular distortion, and there are numbers to show it, is probably the largest in history.”
As Mr Bregman tells it, the flows since the financial crisis out of actively managed equity funds and into ETFs meant a surge of money heading for the largest, most liquid stocks. The original ETF idea has since been tweaked so fund managers do not need to hold every single underlying stock or bond in the index, to “fully replicate” in the jargon, but can hold the largest constituents and still mimic the index’s return (see box). The largest stocks are attracting money purely on account of their size — hence the fears of a bubble.
ETF providers counter that these funds, and passively invested funds in general, still account for just a slice of the market: together they represent just 12 per cent of US equities, and 7 per cent of global equities, according to BlackRock. And the experience of the financial crisis suggests that retail investors will not uniformly sell out when asset values start to fall.
Unusual investment flavours
When it comes to the increasing diversity of ETFs, it may come as a surprise that some providers are critical of the trend. “What we don’t do, and what we won’t do, is proliferate our product range with lots of niche products,” says Vanguard’s Mr Fitzgerald. “We are not out there chasing fads.”
ETFs are sometimes portrayed as a portfolio management tool, allowing investors to take targeted exposure to a particular investment “theme”. If they think the market is, for example, too bearish on certain European countries, these low-cost investment products allow them to put their money where their mouth is.
But when it comes to products such as country-specific ETFs, Mr Bregman questions whether investors are getting what they think they are getting. Take the iShares MSCI Spain Capped ETF. The top five holdings, as given in the fund documentation, are lenders Banco Santander and BBVA, telecoms group Telefónica, Inditex, owner of fashion store Zara, and travel IT specialist Amadeus. They make up half of the fund. None makes more than a quarter of its revenue in Spain.
You can repeat the same exercise elsewhere. “These are multibillion-dollar, multinational companies and that’s all the ETF can really afford to buy; the rest of these companies are too small,” says Mr Bregman. By the same token, he argues that the big-cap equities that are bought are overvalued for what they are. “These are large, generally mature companies that are overpriced because they get automatic bids every day that net inflows come into these ETFs.” The question is what happens if the support of those automatic bids is taken away.
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Whether or not ETFs bear some of the blame for the high valuations being put on public equities, those high valuations do pose a risk for new investors. Currently, the historic price-to-earnings ratios of the UK’s FTSE All-Share, Europe’s Eurofirst 300 and the US’s S&P 500 indices all sit above 20, a level at which past experience tells investors to be conscious of the downside.
If the robustness of ETFs as an investment vehicle has yet to be tested by a sustained market sell-off, there have been other signs to unsettle investors. ETFs played a role in the flash crashes of May 2010 and August 2015, as the market-making activity that underlies even the most straightforward fund broke down. The US Securities and Exchange Commission’s review into the 2015 episode makes sober reading.
According to the SEC, exchange traded products (including ETFs and more) “experienced more substantial increases in volume and more severe volatility” than standard stocks. Perhaps more concerning was its finding that extreme swings in price “seemed to occur idiosyncratically among otherwise seemingly similar ETPs”.
The market making activity behind ETFs (see graphic) is intended to make sure that the fund rarely trades at a discount or premium to its net asset value: in other words, it mirrors the value of the stocks or bonds held within it. But this relies on the market makers, so-called “authorised participants” — commonly an investment bank — buying when units are at a discount to the underlying assets, and selling at a premium. The suspicion is that those players are happy making a margin by providing liquidity in calm markets, but that they will disappear if things get choppy.
There are nonetheless reasons to be optimistic. In the largest products, where most of the money sits, about 90 per cent of trading that occurs is in the secondary market, according to Vanguard’s research. That means ETF investors are passing investments between themselves, and not having to transact with fund managers. Those defending ETFs argue that there is a range of investors with different time horizons, including longer-term investors who will hold through the cycle.
If buyers could not be found in the secondary market, the market makers will turn to the fund managers, or “sponsors”, to source the units. In the worst-case scenario — the manager struggles to sell the underlying securities — the ETF investor could be handed them in lieu of cash. So when buying an ETF, an investor should consider whether they are happy, in an extreme case, to end up holding those underlying investments. Would you be happy to dispose of some high-yield bonds?
Regulators around the globe are running a fine-tooth comb over ETFs and scrutinising their effect on markets, with Ireland’s central bank and authorities in France and the US among those reviewing the sector. The landscape is likely to change.
If ETFs are feeding a stock market bubble, there are ways to mitigate its effects. Fund buyers wanting to avoid the market cap bias can aim for equities that do not get picked up by the major indices, perhaps because they do not meet liquidity or ownership requirements. Or they could still use an ETF, but one that screens for companies with a smaller market capitalisation. If they are intent on “buying the market”, experts suggest that physical ETFs backed by liquid underlying markets have lower risks.
The ETF is clearly here to stay, and there are reasons to believe an accident is no more likely to befall this type of fund than any other. But the era of net inflows will end at some point, and if it occurs during a market sell off, the fund and its market making infrastructure will be sorely tested. In the meantime, as with all investment decisions, it is worth reading the fine print.
Check your ingredients
There are a series of risks and performance factors to which ETF investors are exposed, depending in some cases on the type of fund held.
Counterparty risk: “Synthetic” ETFs bear the risk of failure of the counterparty, such as an investment bank, on the other side of the investment swap from the fund manager. The collapses of US banks Lehman Brothers and Bear Stearns during the financial crisis show that this worst-case scenario can happen. Investors should examine what collateral is being held against the swap by asking the provider or reading the fund prospectus.
Tracking error: This is the extent to which any ETF deviates from the index that it is set up to mimic. Managing this is a key job for the manager of the fund, and how they have performed is something for the private investor to look at: they can compare the fund’s record with the selected index in the fund documents or on the manager’s website. Some asset classes, such as emerging markets, are likely to demonstrate more tracking error than others.
Liquidity risk: Ultimately, the ETF is as liquid as the market it is tracking. In times of market stress, investors will be able to get their money out more easily from a highly liquid, diversified market.
Sampling: This is related to tracking error. Some physical ETFs do not buy every security in the targeted index or category, perhaps because of the number of constituents. If the fund is small relative to the index, managers may sample from the index. Investors can check whether the fund they are buying is fully replicating, or whether sampling is involved. Again, it is worth checking the prospectus, or using third-party data providers such as ETFGI.
Asymmetric information: Even if the ETF fully replicates the index, the make-up of the index itself may mean that investor’s true exposure does not fit with what they have signed up for. If the fund is tracking a market capitalisation-weighted index, buyers may not be aware of the concentration among the very largest companies. If they are hoping to invest in a particular theme, such as a country-specific equity fund, their exposure may be biased to a few multinational companies. “There needs to be much more attention to the construction of indices,” says Markus Stadlmann, chief investment officer of Lloyds Private Bank. “Does the index meet the investment objective?”
Asset exposure: ETFs do not need to hold cash to meet redemptions, so investors switching from an open-ended fund may not realise that they have more exposure to the underlying asset than they did before. They may not realise they are making a decision that affects their risk profile.