Systemic Risk in ETFs

The explosion in Exchange Traded Funds threatens to make the industry a systemic risk. Regulation has focused too narrowly on the problems of 2008, overlooking the huge growth in new products since then. ETFs were a relatively small part of capital markets during the last crisis, but since then have taken off in complexity and scale.

ETFs have gone mainstream, with widespread use in institutional as well as private client portfolios. The funds look like an attractive way to skip the fees of active management, and target niche investment areas or strategies. But, do investors really understand the risks? There are now thousands of ETFs and similar exchange traded products, with many of the exotic funds too complex for anyone but their creators to understand. European legislation is tightening, but looks like it is not moving fast enough to keep up with the rapid change.

Less sophisticated investors wrongly think that the main risk distinction is between physical ETFs, believed to have lower risk, and the synthetic ones that make greater use of derivatives. In practice even physical funds can be involved in stock lending, and some other credit risks. Some providers have labelled their synthetic ETFs with the term swap but leave investors to read the small print.

The European regulator, ESMA, has noted that the distinction between physical and synthetic is often blurred and instead left the explanation to the detailed investor information documents . Clear labelling should be mandatory. The less sophisticated investors involved are not just private clients, but include charity trustees and local authority funds, often attracted by the apparent low costs.

Regulator, ESMA has focused on the problem of securities lending, and on disclosure of methodology for index calculation. But no cap will be put on stock lending by funds. Investors will benefit from fees for lending, but overall the new rules will tilt the scales in favour of synthetic funds. And the greater transparency being introduced on the funds may make it easier for hedge funds to make bets against ETF strategies.

While some ETFs may be too complex for the average investor to understand fully, more sophisticated market players attempt to model them. Funds that buy and sell automatically, to a prescribed formula, set their strategy up to be gamed by others; hedge funds can work out what these funds are likely to do next and take advantage. Previously, betting against passive investing meant no more than calculating what would go in or out of an index. Now arbitrage is more complex, but nevertheless offering profits for the few smarter investors.

ETFs risk systematically being forced to trade with hedge funds that are one step ahead.

The real dangers are in the complex synthetic ETFs that offer the prospect of bets on market direction, but tend to work best when a particular sequence of events happens in a planned timescale. These can in theory offer useful and low cost hedging, but at times have delivered unexpected outcomes. ETFs may not actually mimic the price action of the underlying asset as well as they should. Leverage on a targeted reference index can be 200% or more in some funds.

This year has seen more ETFs launched that attempt to replicate hedge fund risk adjusted returns, without the high costs and lock-ups usually involved in traditional hedge funds. But with the average hedge fund lagging equity markets over the past two years, the appeal of these esoteric ETFs may be limited. Simply holding a passive portfolio of hedge funds would not cut costs, so many of these ETFs instead use futures to target hedge-like performance. But this involves complex strategies and brings in risks that investors may not understand.

ETFs have few trading restrictions, and their simplicity can lure investors into overtrading and high transaction costs. Investors also believe that they get better control, and so often use stop-loss and limit orders. This faith in control and liquidity could be tested. The funds’ promise of enabling investors to instantly reallocate capital will become more challenging as the industry grows. Already it is estimated that exchange traded products represent 30% of trading volumes in some major markets. Where ETFs involve less liquid areas such as emerging markets and small cap, the risks are already evident.

Not all investors use the vehicles for core long-term strategies. A number of exchange traded products have been created specifically to serve the direct needs of trading firms or banks themselves. This creates a potential systemic hazard, as there may be more need for liquidity in these products at times of market stress. In a sell-off, such exchange traded products could become a transmission mechanism, increasing the linkages across investors, markets and sponsors.

This was highlighted in the 2010 Flash Crash, when two thirds of US broken trades were from ETFs. What happened suggests that growth of ETFs will increase market correlation. The problem is that intrinsic value of stocks matters little in the automatic processes of these funds. They have no anchor from the intrinsic value of stocks they hold. Instead, they rely on the prices other active market participants set. ETFs do not contribute to price formation themselves, but depend on the judgement of investors who research stocks to set prices based on fundamental analysis. A sudden market shock, or loss of confidence in market prices, can quickly trigger panic selling. ETFs do add market liquidity, but their lower costs owe a lot to others conducting company research.
The potential systemic risk from having too many funds trading automatically, focusing on relative but not fundamental value, needs study by regulators. And, investors need to understand how an ETF will behave under different market conditions. Better labelling and cost disclosure is needed. The very success of the industry, driving it into the investment mainstream, now requires it to be taken more seriously in regulation.

This article is for informational purposes only. The opinions in this article are the author’s own. The information presented in this article has been obtained from sources believed by the author to be reliable, however, he makes no representation as to their accuracy or completeness and accept no liability for loss arising from the use of the material. Colin McLean may have an investment in any of the companies mentioned in this article.