There’s been much ado about ETFs on the regulatory front in recent weeks. Fears of systemic risk have been expressed by global watchdogs like the Financial Stability Board, the International Monetary Fund and the Bank for International Settlements. As the global ETF market proliferates, parallels are being drawn between the burgeoning market for synthetic ETF products and the collateralized debt obligations (CDOs) that fueled the subprime mortgage crisis.
Regulators are right to look at the risks in ETFs—especially as the market continues to grow rapidly (it topped a trillion dollars this year). But growth in the ETF space hasn’t been fueled by innovation alone – it’s been driven by investor demand for lower cost alternatives to the higher fees paid to fund managers, particularly on the retail side.
In their simplest form, ETFs are easy to understand—they track major indices, they’re highly liquid, and they’re cheap. Those three features make them innately attractive to investors, especially in the wake of two major market crises in the space of a decade.
But while the value proposition is easy to see, investors—especially pension funds—need to make sure they understand how ETF providers actually deliver on it. How are ETFs built and how do they work—and is there any counterparty risk involved?
Plan sponsors using ETF-based strategies must also take steps to understand whether or not providers can handle the transparency and liquidity that required in the pension space—and they need to pose these questions to providers up front.
No doubt, ETFs will continue to grow in pension portfolios—cheap and liquid, ETFs are really tempting, especially at a time when cost management is such a big focus for plan sponsors. ETFs represent a straightforward proposition – but plan sponsors still need to look under the hood to see what’s in there.
