Last week, London-based research firm ETFGI announced that global exchange-traded fund assets hit yet another record high, topping out at US$2.926 trillion at the end of the first quarter of 2015.
The lion’s share of assets sit in the U.S. (US$2.094 billion) followed by Asia Pacific ex-Japan (US$119.6 billion) and Japan (US$109.3 billion). Japanese ETFs have become a hot ticket ever since the Japanese government started pumping money into them as a policy plan to juice the economy via the lagging stock market.
That’s a lot of money flowing quickly into ETFs—and it’s money driven by a huge number of investors who are counting on one universal thing: liquidity. ETFs have grown assets because they serve up liquidity at a time when it’s become of paramount concern to investors. Consider that globally the ETF industry how has 5,669 ETFs, with 10,961 listings, from 247 providers listed on 63 exchanges in 51 countries.
The growing size of the ETF industry is bringing a renewed round of regulatory scrutiny, this time from the International Monetary Fund which has issued a report called Navigating Monetary Policy Challenges and Managing Risks.
Granted, the industry is used to regulatory attention—the 2010 Flash Crash was blamed by some on ETFs (albeit wrongly in the end). This time, however, the IMF isn’t pointing simply to issues such as leverage or technology—it’s cutting to the very heart of what ETFs offer investors: liquidity.
According to the IMF, ETFs and their mutual fund counterparts create the risk of a market run due to “easy redemption options and the presence of a first-mover advantage.”
As the report explains, “the resulting price dynamics can spread to other parts of the financial system through funding markets and balance sheet and collateral channels.”
The worry here is that herding among managers and investors is on the rise—and the collective size of that herd could do some serious damage to global financial markets if left unchecked.
While that is a concern in equity markets, the IMF is concerned about the role of fixed income ETFs and mutual funds, which have expanded significantly. In particular yield-hungry investors have led funds to invest in “less liquid assets.”
The report offers up a few recommendations to strengthen regulation, including addressing liquidity and perhaps adding some barriers to quick and easy redemption. A couple of interesting points:
- “liquidity rules, the definition of liquid assets, investment restrictions, and reporting and disclosure rules could be enhanced.”
- “consideration should be given to the use of tools that adequately price-in the cost of liquidity, including minimum redemption fees, improvements in illiquid asset valuation, and mutual fund share pricing rules. “
So, investors should be paying for added liquidity and—even more importantly—they should understand how that liquidity is being delivered. Those are two rather significant suggestions—and they could lead to a number of outcomes with different levels of impact on investors and the larger asset management industry. The liquidity premium is alive and well in many areas of the market—so why not in the ETF space?
What do you think—should investors pay more for liquid assets? Or is that already being priced in by providers?