Exchange traded funds (ETFS)have been a huge success but now there are fears that they are too big and could upset markets.
David Jane, a Milton Asset Management fund manager, commented recently that some people suppose that “ETF buyers are not a herd, chasing the same fashions and trends - when clearly they are.”
Other industry commentators agree and are also worried about investment in market indices generally and in particular in the ever-growing number of exchange traded funds (ETFs).
They are increasingly apprehensive about the underlying worth of ETFs distorting markets, the market behaviour of such funds and the way investors show a herd like drive to keep buying this type of investment.
What are these tradeable funds?
An exchange traded fund is a tradeable security, for example it can invest in the constituents of an index (like S&P500).
The exchange traded fund is created to replicate the performance of a particular investment or invest direct in the equities of companies of a sector such as health, technology, commodities or bonds.
Some market observers feel that, particularly in the US, ETFs have come to dominate retail flows, with the increasingly less popular managed funds losing investors to ETFs.
A worrying event on 24 August 2015
A significant incident to do with ETF liquidity took place on 24 August 2015. It was a volatile day during the Chinese market crash, and 1,000 trading US securities were suspended.
This upset the arbitrage mechanism of some ETFs so their price fell below the indices they were programmed to track.
Luis Aguilar, commissioner of the Securities and Exchange Commission expressed regulatory concern: “Should we consider curtailing the growth of ETFs?” The SEC got under way a review of the EFT market in October 2017.
The US Securities and Excahnge Commission. Souce Shutterstock.
There is some fear that the world of the ETF could lose liquidity and let down millions of investors. There are worries about some ETFs asset values are now too big and other ETFs too specialised and non- transparent for comfort.
In a nutshell, what happens when, and if, the ETF ‘bubble’ bursts, instantly the herd gathers to sell and maybe it can’t? ETF providers don’t want to think about what would occur if there was some sort Armageddon caused by ETFs.
After the fall, more appreciation of ETFs
Exchange traded funds first appeared around 2000 but have been a strong investment choice for investors since 2009 when it started to become hard to find decent income.
In 2008 there were $710.7bn assets under ETF management, by April 2017 there were over $4 trillion, reported the Financial Times.
In 2003 there were 276 different ETFs worldwide, in 2016 there were 4,779 according to Statista. European ETFs now exceed 2,000 from nothing in 2001.
After the financial crisis of 2008 a lot of ordinary investors realised that ETFs could provide a cheap, tax efficient, tradeable investment in a range of sectors.
The vast majority of ETFs are equity-orientated, then fixed income, commodities, multi-asset, alternative, then currency funds.
ETFs usually invest in the physical shares in companies, even when they mirror an index, though it is a bit different when it comes to commodities and foreign exchange.
Unlike mutual funds or oeics, an ETF can be traded like a company share on a stock exchange. ETF prices change as they are traded. Because of this trading many think they are more vulnerable to market issues like volatility and liquidity.
ETFs appealed because they were a passive investment rather than the active investment offered by fund managers who charge fees for their skills.
For the average investor it’s hard to outperform the market with funds and their costs, but with careful use of ETFs, using first off income funds, the idea is that making money is enhanced.
When creators fear their creation
The founder of big US ETF provider, Vanguard, is Jack Bogle. He went on record as having doubts about the robustness of the EFT space.
Interesting comment because Bogle set up Vanguard and fashioned the first index fund.
But now he thinks that some ETFs are becoming too “complex and opaque” and that it is time to examine the industry because of its sheer size and “fragility in times of market stress.”
He wonders whether ETFs are the best choice for long term investors.
Defenders of ETFs say that the funds are as resilient as the assets they are invested in, like the shares of a quoted company. They say that if the ETF is of good quality it should be able to ride the waves of a market storm.
One plus for ETFs is that the investor actually owns the underlying assets of the ETF, unlike with a fund. So that if the provider of the ETF fails or the investment cannot be sold, there is at least some sort of payback for the investor from the asset.
Many say that the plain vanilla ETFs have got through stress times well. They point to the esoteric, for example leveraged or short position ETFs, and high yield bond ETFs, both of which are high risk in more senses than one and not for the ordinary investor.
Adam Laird, head of ETF Strategy, Lyxor ETFs. Source LyxorAdam Adam Laird, head of ETF Strategy, Lyxor ETFs. Source Lyxor.
There is still plenty of belief in the continued success of ETFs
Adam Laird is strategic head of Societe Generale’s Lyxor ETF. A big ETF provider in Europe, Lyxor has just released two new ETFs – one is called Lyxor FTSE UK Quality Low Volatility Dividend, designed for income and invested in consumer stocks.
Despite the critics, Laird is optimistic about ETFs.
He agrees that, “With ETFs I think there is a danger of creating a whole market many times a day: buy in the morning and sell at lunch time. But sensible investors need to be responsible.
“Rather than constant buying and selling, If anything, I’d say there are more investors who buy ETFs and then forget about them.”
“There are esoteric ETFs, but many of them are designed for institutions with most of their money is in government bonds. Pension funds find ETFs useful and they can afford to back a specialist ETF which would be too high risk for an individual.”
The EU is introducing new ETF regulation, MiFID II, in January 2018 which is to be all about transparency, with the investor getting a better idea of what is involved.
The industry expects MiFID II to make investing in EFTs that much understanable. Will that mean more herd instinct?