Exchange-traded funds: Emerging Trouble in the Future?


20141025_FNC897COULD the hottest trend in investment management be the greatest danger to financial stability? Exchange-traded funds (ETFs)—pooled portfolios of assets that trade on stockmarkets, usually linked to an index—have grown from a total value of $416 billion in 2005 to $2.5 trillion today. Their rapid growth has left regulators worrying about what might happen if the money that has flowed into ETFs decides to flow out again.

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Investors can sell their holdings in ETFs throughout the day, but the assets of some ETFs may be hard to sell immediately. One obvious area is the corporate-bond market, where banks have retreated from trading, and so hold less inventory. There are some 46,000 separate bond issues, not all of which will find ready buyers during a rout.

In other words, there is a potential mismatch between the liquidity of the funds and the liquidity of the assets they own. A stampede out of ETFs might cause a fire sale of assets that would ripple through the financial system. Defenders of the industry, however, say these concerns are overstated; after all, it weathered the sell-off in equities and corporate bonds in 2008-09.

To understand ETFs fully you need to know about their antecedents. They are the crossbred offspring of two earlier types of pooled portfolios: mutual funds (or unit trusts) and investment trusts. From the former, ETFs have inherited an open-ended structure, meaning that the size of the fund rises and falls in line with demand from investors. From the latter, ETFs have inherited the ability to be traded between investors on a stock exchange (mutual funds can only be bought and sold once a day, through the manager of the fund).

This hybrid has immense appeal. For retail investors, ETFs provide a cheaper route into many assets than that provided by most fund managers: the average expenses on an ETF are around 0.25% a year compared with the 1-2% charged by most mutual funds. The biggest ETF, which tracks the S&P 500 index, has expenses of just 0.09% a year. The range of assets covered by ETFs (from property to emerging-market bonds) provide an easy way for wealth managers to give their clients exposure to different markets. And ETFs provide a quick way for big investors to get access to a market while they work out which shares or bonds to buy.

An ETF is created by a fund-management company, which chooses which index to follow and markets the fund to clients. BlackRock, through its iShares brand, is by far the largest ETF manager; Vanguard and State Street are its biggest competitors. If the index is liquid enough—a leading stockmarket, say—the manager might replicate it, buying all the stocks or bonds and weighting them to match the proportions in the benchmark. More commonly, the manager will choose a representative sample of securities intended to track the index, and adjust that sample over time to try to keep in sync with the benchmark. Almost as important for the ETF are the authorised participants, or APs, which act as marketmakers. The APs, most of which are banks, help to keep the share price of the ETF close to the value of the underlying assets. Imagine that one big investor in an ETF with, say, a 10% stake, wanted to sell its holding in a single day. There might not be ready buyers for such a large holding, causing the ETF to fall to a price below the value of the assets it owns.

To avoid this, the APs act to balance supply and demand. If the ETF is expanding (more people want to buy shares than to sell), then the AP puts in an order to the fund manager for a block of new shares, dubbed creation units, in the ETF. In return, it transfers a bundle of securities, based on the index the fund is tracking, to the manager (this bundle is known as the creation basket). If the ETF is shrinking (more people want to sell than to buy), then the AP sells creation units to the fund manager and receives in return a bundle of securities known as the “redemption basket”.

The AP can also keep the price of the fund in line with its assets through arbitrage. The asset value of the ETF is published on a regular basis during the day; if the price of the ETF is higher than its underlying assets, then the AP (or any big investor) can sell ETF shares and buy the underlying assets. If the price is lower, they can buy ETF shares and sell the assets.

So how might this process go wrong? One obvious danger might be the role of the APs. If they fail to make a market in the security, then the price could get out of kilter with the asset value of the fund. Alternatively, they might go bust in the middle of the creation or redemption process, which takes three days to complete. That might leave the ETF short of the shares needed to top up the fund (and match its benchmark) or the cash to pay its investors.

The industry says that it is well protected against such events. First, it does not depend on a single marketmaker or AP; BlackRock says it uses more than 40 across its range of funds. Second, most ETF trades in America are conducted through a clearing house such as the National Securities Clearing Corporation (NSCC) which will stand behind the deal if the AP fails. Where a trade is not conducted that way, the AP will be required to post collateral; if it goes bust, the ETF gets the collateral. Third, the vast majority of trades occur between stockmarket investors, not between the ETF manager and an AP. An analysis by the Investment Company Institute, an industry lobby group, found that only 9% of all trades were creations and redemptions for equity ETFs and 19% for bond funds. Even for the bond funds, daily creations and redemptions were just 0.34% of asset value.

What about the liquidity mismatch? There was a good test of the system’s robustness during the summer of 2013, when the Federal Reserve hinted it might soon start reducing its asset purchases. This caused a sell-off in bond markets, dubbed the “taper tantrum”. One bond fund, BlackRock’s high-yield ETF, traded $1 billion in a day. Even then the amount of secondary trading (between investors) outstripped primary trading (between the manager and the AP) by five-to-one, BlackRock says. The ETF traded briefly at a discount of 2% to its net asset value, but it quickly corrected. When markets wobbled earlier this month, there were no reports of problems.

Even in the case of corporate-bond funds, it is hard to see how things could go badly wrong. The total assets of corporate-bond ETFs are $141 billion, compared with annual bond issuance of $3.2 trillion in 2013. In other words, ETFs comprise only a tiny part of demand for the asset. Unlike banks or hedge funds, most ETFs do not use borrowed money, or leverage. There will doubtless be individual ETFs that get into trouble in the future; there will probably be scandals. Some will suffer spectacular falls in value, just as technology funds plunged in the early 2000s. But that does not make them a systemic threat.

Babatunde Akinsola
Babatunde Akinsola
Babatunde Akinsola is aNaija247news' Southwest editor. He's based in Lagos and writes on the Yoruba Nation political issues, news and investigative reports

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