The tremendous growth rate of assets invested in passive investments vehicles we witnessed during the last decade reflects recent trends in the investment’s world. In an environment of low interest rates, high volatility in the markets, and higher transparency vis-à-vis fees, retail and institutional investors alike are increasingly looking for cost-effective ways to allocate their assets. From this standpoint, investing in exchange traded funds (ETF) seems to offer the best of both worlds, i.e. diversification at a minimal cost. As reflected in the data, global assets invested in ETF indeed increased at an annualized rate of nearly 20% over the past 6 years, and are poised to more than double by 2023. The ETF market now accounts for more than €2.85 trillion in assets under management, or 7% of all collective investment assets globally. This article aims to understand if the rise in ETF investments could be seen as the premise to a bubble, and assesses the regulatory and market control mechanisms in place to protect investors during stressed market conditions.
Breaking down ETF
An exchange traded fund is typically a passive investment vehicle structured as an open-ended fund that is designed to track a specific benchmark index and replicate its performance. This could be done either via physical replication of the index (true ownership of the underlying securities) or via synthetic replication by entering into an equity linked swap (ELS) with a third-party agent. Unlike mutual funds shares which can only be traded once a day at its closing net asset value (NAV), ETF shares (or units) can be bought or sold like common stocks at a market-determined price throughout the day. The ETF market relies on a process of creation/redemption of units, involving 3 main parties: the ETF Sponsor (the ETF management company), the Authorized Participant (usually a bank, or a broker-dealer entity) and the end investor. When an investor wants to buy an ETF, she will turn to her local Authorized Participant (AP), who will collect the cash to purchase the underlying basket of securities (creation basket) in the market and deliver those to the ETF Sponsor. In return for the securities the AP receives a “creation unit”, i.e. a large block of typically 50,000 ETF shares which may then be sold in the secondary market to retail investors at the current market price. When the same investor wants to redeem her shares, the opposite movement takes place. This process is driven by supply and demand of ETF shares in the market, which could lead to discrepancies between the price of the ETF unit and the indicative net asset value (iNAV) of its underlying basket of securities. The AP would then exploit this price difference and realize a risk-free arbitrage profit thus bringing back the ETF share prices at the equilibrium.
The Good, the Bad and the Ugly
Investing in ETF is seen as a cheap and tax-efficient way to achieve exposure to global markets, and to access certain asset classes which are out of reach for most retail investors. ETFs indeed combine the advantages of a diversified portfolio of securities with simple equity-like characteristics such as a higher liquidity and the ability to use market, limit and stop orders, while keeping management cost at a minimum. Nonetheless, these advantages come at a cost:
Firstly, under stressed market conditions an ETF Sponsor could find it impossible to trade the underlying assets and ultimately refuse to redeem units. This happened on July 20, 2015 to Lyxor, an ETF Sponsor, after the closure of the Greek stock exchange. In such a volatile environment, price discovery was impeded, leading to the trading suspension of the ETF for nearly a month. As the market becomes opaque, mixed signals are sent to active investors about the fair value of a stock. This could lead to significant misallocation of capital, further aggravated by the speed at which trading is done. With high-frequency trading (HFT), the average holding period for a security on the NYSE has fallen from 2 months in 2008 to 20 seconds today.
Secondly investors should be aware of the proliferation of ETF’s and the increasingly granular exposure choices they offer. The narrowness of the funds mandate in terms of asset specification as well as the specific weighting methodology in calculating the index, can result in skewed returns and bias the investor’s decision. This risk is illustrated by the performance of Technology Select Sector SPDR ETF (XLK) in 2014. XLK has a total of 71 holdings and the index it tracks is market-cap weighted. One of the main underlying stock of the index is Apple which makes up 15% of the value of the fund. Since this company has significantly outperformed the market that year (+25.5%), it has had a huge impact on XLK’s performance. Excluding the impact of Apple’s individual performance, the performance of the ETF is almost halved. It should be noted concentration risk in ETFs are mitigated by regulatory measures to some extent. Yet it illustrates the importance to investors to not only understand how the composition of an ETF fits in a particular investment strategy but also to understand the consequences of the constitution and weighting methodology of these products and the added exposure they might bring.
Thirdly, the AP could find it impossible to absorb massive redemption orders due to liquidity shortage and may have to withdraw from the market completely. By interrupting its role of arbitrageur, it automatically transfers the stress onto the underlying assets. ETF liquidity indeed depends on the liquidity of the underlying assets and on the AP’s presence in the market. A striking example occurred in June 2013 when Citigroup suspended redemption requests after reaching an internal collateral limit. Academic literature has shown that this liquidity shock could spill over to the underlying market, adding a new layer of “non-fundamental volatility” in assets. Another study concluded that ETFs could even increase daily volatility of the underlying stock by 3.4%.
A bubble occurs whenever an asset is trading at a price that strongly exceeds its intrinsic value. In normal times the day-to-day arbitrage activity by the AP will minimize the tracking error[gl1] , i.e. the standard deviation of the difference between the return of the vehicle and the return of the index it tracks. However there have been instances in the past where abnormal differences between the intrinsic value and the traded value of the ETF were experienced. On August 24, 2015, concerns about weak global growth and events on the Chinese markets caused significant but temporary price distortion leading the Guggenheim S&P 500 Equal Weight (RSP) ETF50 to trade at nearly 65% of its theoretical net asset value.
Long-term structural discrepancies between the intrinsic value of an ETF and the underlying securities could nonetheless happen if excessive ETF inflows flood in markets too thin to handle them. In a bull market ETF Sponsors have to indeed buy more and more of the underlying securities rising in price, thereby inflating those prices even more. This decorrelation of liquidity could potentially fuel speculation, and further propagate a bubble. For example, Nomura Asset Management had to stop subscriptions for some of its leveraged ETF for two months, as they represented almost 25% of all open positions on the Nikkei stock exchange.
If the market share of ETFs is big enough to move the underlying market as a whole and if ETF providers continue to disregard fundamentals, this situation could potentially lead to a bubble where oversold ETF shares cause underlying stocks to be overbought. This could theoretically increase the risk of sudden capital outflows, thus increasing systematic risk.
Since most European ETFs are subject to UCITS regulation, they must comply with strict portfolio diversification, leverage criteria and maximum counterparty exposure. These rules, along with the current focus on transparency initiated by MiFID II are more relevant than ever in an environment of increased specialization of the ETFs offered to the general public. The use of liquidity management tools, and the development of fund stress testing principles by ESMA should further help the investors to assess the risks when investing in such products.
In times of high volatility, the circuit-breaker mechanism which sets continuous limits to the maximum possible discrepancy between the intraday value of underlying index NAV and the ETF share price seems to be the only safeguard that has been successfully employed in the US and in some European markets so far. When the limits are reached in the stock exchange, a trading interruption (reservation) occurs, leading to a subsequent auction. It is important to note that the trading activity can nonetheless continue in the OTC market during these periods.
Global investments in ETF have increased drastically during the last decade, encouraged by changing investment’s behaviors and a transition towards fee-based business model for financial advice. ETF have been branded as a cheap, simple, and tax-efficient way to achieve both liquidity and diversification. We have seen that these advantages should be weighed against the new risks these products involve. The illusion of liquidity could blind investors and drag the price of the underlying assets away from their fundamental value. The concentration of assets within some specialized ETF could skew the performance of the fund towards the performance of its largest holding. The redemption and subscription mechanism is highly dependent on the market-making activity of the AP, who could unilaterally decide to withdraw from the market in case of extreme volatility. The ETF Sponsor could also refuse to redeem shares when trading the index become complicated. When the ETF represents a big portion of a market, large inflows or outflows in and out of the funds could exacerbate the volatility of the securities on the exchange and lead to speculation.
Even though the world of ETFs is increasingly subject to regulatory scrutiny, the investors should be aware that there is currently no real protection – apart from the circuit-breaker mechanism - against massive financial turmoil, and the value of their ETF shares is influenced not only by the value of the underlying basket of securities but also by the supply and demand activity on the exchange. Given current growth forecasts, it seems important to draw investors' attention to the inherent risks of such a 'passive' investment strategy. More in-depth studies will be needed to determine if the current frenzy around ETF and the massive subscriptions in those vehicles are indeed the warning signs of a bubble.
Gilles de Schrevel, is consultant Risk Management at Initio since 2016. He’s graduated from Solvay Business School (Master degree in Business Economic - Corporate Finance & financial markets).
Maxime Liénart has over 5 years of experience in Asset Servicing and Global Custody with roles combining both operational coordination (orders processing and monitoring) and client knowledge as their dedicated representative. He serviced and built a solid relationship with a broad range of institutional investors, and specialized more recently in the Luxembourg offshore funds industry.
Laurens Verelst, joined Initio in 2018 after having worked as a financial management consultant for two years. He is a CFA level II candidate with an appetite for knowledge and a keen interest in the investment industry. As a consultant he is developing expertise in funds and securities at a major European asset management firm.
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 Some ETF are also actively managed.
 In Europe, most ETF are UCITS or AIF. In the US, most ETF are UIT.
 For the sake of simplicity, we will only consider passively managed, physically replicated ETF in this article.
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 Conversely, an equal-weight index will tend to perform better than a market-cap weighted index in environments that favor smaller stocks.
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