Exchange-traded funds have become popular among investors, institutional and retail alike – so much so that their asset-gathering is one of the few bright spots in what otherwise seems to be a moribund investment management business. However, they have grown well beyond the diversified, broad index portfolios that more or less track a standard benchmark. Instead, they can get exposure to small slices of the equity pie, or even to hard-to-trade assets, such as commodities.
The morphing of ETFs has caused some trepidation among regulators and market participants. In the U.S., a subcommitttee of the Senate Banking Committee held hearings in October last year to examine whether ETFs have departed so much from their traditional moorings as to become a snare for the unsuspecting.
Eileen Rominger, Director, Division of Investment Management at the U.S. Securities and Exchange Commission notes that ETFs account for $1 trillion in assets, or one-tenth of total mutual fund industry assets. They have a substantial market share and are growing. The problem is mostly how they are growing.
The worry is less with ETFs that hold the underlying shares of the indexes they track. It’s more with ETFs that mostly use over-the-counter swaps to replicate or synthesize exposure to the futures or commodities markets. As a result, the SEC has stopped giving exemptive relief to ETFs that rely heavily on derivative or swaps. As Rominger explains:
“For example, some [exchange-traded products], in the form of commodity-based trust-issued receipts, seek to track an index of futures on volatility of a portfolio of stocks, such as the S&P 500. Futures on volatility have added another dimension to the calculation to express future or expected volatility. In addition, the Commission has witnessed an increase in the past few years in the variety of actively managed ETFs introduced by sponsors. For example, while an assortment of actively managed ETFs based on fixed-income portfolios is listed and trading in the marketplace, there have been an increasing number of actively managed ETFs that seek to primarily invest in instruments that raise concerns with respect to liquidity and transparency, including emerging market debt securities, high-yield debt securities, and other instruments.”
Despite the concern, such synthetic pools are a small proportion of U.S. ETF/ETP market, she notes: only 3%. By contrast, they have a 10% share in Europe.
Then again, the concern is very real. “[B]ecause ETF share prices are dynamically linked to the prices of their underlying holdings, the trading and other characteristics of the underlying portfolio investments, such as certain illiquid types of securities and particular over-the-counter or ‘OTC’ derivatives, may impact the arbitrage process necessary to closely align the ETF share price with its NAV. In certain circumstances, temporary imbalances in supply and demand might result in the price of the ETF decoupling from the value of the ETF’s underlying instruments as the ETF starts to behave more like a stand-alone product whose price responds solely to whatever liquidity is immediately available in that product, regardless of the value of the underlying investments. Under these circumstances, the ETF can begin to trade at a significant premium or discount to the NAV of its assets.”
That’s a theme close to the heart of Harold Bradley, Chief Investment Officer of the Ewing Marion Kauffman Foundation.
“We believe that these instruments may now be undermining the fundamental role of equities markets in pricing securities to ensure that capital is efficiently allocated to growing businesses. When individual common stocks increasingly behave as if they are derivatives of frequently traded and interlinked ETF baskets, then it is trading in the ETFs that is driving the prices of the underlying stocks rather than the other way around. This tendency is especially pronounced for ETFs that are comprised of small cap stocks or stocks of newly listed companies, that generally are thinly traded.”
In his view, this leads to ever more reliance on untransparently priced derivatives.
“High co-movement of securities is not new, often occurring when markets reflect crowd panic or euphoria. What is new, however, is how ETFs decrease diversification benefits, with stocks and sectors worldwide moving together, even when there is no panic. Stocks move together today more than at any time in modern market history with recent data indicating that individual common stock prices that make up the S&P 500 index now move with the index 86% of the time. … Consequently, market makers can often only match their positions against futures, options or other ETFs, or they must employ derivatives and synthetic securities.”
The result is greater volatility. Are there solutions? Noel Archard, Managing Director at iShares, the biggest provider of ETFs (now owned by BlackRock) draws a line in the sand:
“While the first ETFs were straightforward, tracking relatively broad benchmarks such as the S&P 500 or individual country indexes, today some sponsors have introduced new products of increased complexity that carry greater risk and may not be appropriate for retail ‘buy and hold’ investors. Products which raise such concerns include so-called leveraged and inverse funds … products that are backed principally by derivatives rather than physical holdings. These products require a greater deal of disclosure and up-front work with clients for them to understand investment and structural risks and BlackRock believes that they should not be labeled ETFs.”
The gauntlet has been thrown. Next post: a perspective from Europe, where synthetic ETFs have a much larger market share.