Over the years, exchange-traded funds (ETFs) have attracted their fair share of criticism from market participants, regulators and investors.
In 2000, when iShares launched its first two ETFs in Europe, commentators speculated that the infamous YK2 bug would bring down funds, and the rest of the world as we knew it.
The Millennium bug came to nothing, but fears remained about the stability of the ETF market. The 2010 flash crash in the US, which saw markets lose trillions of dollars in minutes thanks to rogue algorithmic trades, fuelled further concerns that ETFs could exacerbate a downturn. The following year multiple European regulators said synthetically backed ETFs were opaque and a “source of contagion and systemic risk”, prompting many European issuers to re-align their product ranges.
In 2016, research and brokerage firm Sanford C Bernstein & Co declared that passive funds were “worse than Marxism” as they undermined the social value of active management and threatened to eradicate modern-day capitalism.
But ETFs continued to grow throughout the tech bubble of 2000, the financial crisis of 2008 and through Brexit uncertainty, accounting for $4.8trn (€4.1trn) in assets as of June 2018, according to ETFGI.
And almost two decades on from their launch in Germany, the iShares Stoxx Europe 50 UCITS ETF and the iShares Euro Stoxx 50 UCITS ETF have combined assets of more than €5bn.
“The European ETF marketplace has seen tremendous growth in recent years, with expansion in the number of strategies on offer,” says Hortense Bioy, director of passive funds research at Morningstar.
She adds: “This calls for renewed education efforts for professional and retail investors.”
Education is critical – not least to bust some of the myths surrounding ETFs. Here is IPE’s guide to cutting through the hype of how exchange traded funds work.
ETFs are overtraded and can cause markets to fall
In May 2010, the flash crash had come and gone within little more than half an hour, yet indices such as the Dow Jones had dropped by around 9%. They recovered quickly, but in the aftermath jittery investors searched for culprits.
The US Securities and Exchange Commission said ETFs played a significant part in the fall, with 68% of more than 21,000 cancelled trades coming from ETF investors.
“Post the 2010 hiccups, the exchanges enacted rules which have so far mitigated the problems we saw back then,” says Dave Nadig, CEO of ETF.com, referring to trading limits designed to prevent sudden changes in securities’ prices. “I’d expect them to continue to work.”
Investors in active funds are also prone to knee-jerk reactions. Data from the UK’s Investment Association found that retail investors pulled £6.7bn (€7.5bn) from UK actively managed funds between the Brexit referendum in June 2016 and March 2018, despite healthy UK market returns of around 17% in that period.
It is difficult to compare exactly with ETFs, although TrackInsight data shows that global inflows into ETFs tracking UK equities grew by around €1.3bn over that period, with the vast majority (€1.2bn) going to the iShares FTSE 100 UCITS ETF.
It is worth noting that the European ETF market is dominated by institutional investors, while retail investors drive the US market, according to Cerulli Associates.
“We don’t see any overtrading by our institutional customers,” says Simon McGhee, director of ETF business development at market-maker Bluefin Europe.
Pension funds are exceptionally cost sensitive and tend to trade monthly to cover their liabilities, he explains, while the most aggressive institutional traders would be smaller hedge funds who trade more often and need to outperform their given benchmarks. More conservative users such as private banks and wealth managers tend to use ETFs for long-term investing within discretionary portfolios, he adds.
In addition, the ETF market tends to be overstated relative to the size of the overall stock market. According to Morningstar, ETFs tracking US equities represent less than 10% of the US equity market and, in terms of trading, ETFs account for less than 5% of equity daily volumes.
“With that in mind, it’s difficult to believe that ETFs could cause a downturn in the market,” says Bioy.
ETF assets will grow to overtake everything else and make markets inefficient
Some argue that passive funds rely on the research of active managers to determine stock prices, and if everybody indexed, then stocks would be mispriced and the market would fail. However, many ETF experts say this would never happen.
“As much as 60% of securities in the Russell 3000 in just 25 years has out- or underperformed [the broader index] by 10% in the last 25 years,” says Thomas Bartolacci, head of European capital markets at Vanguard. “The ability to under- or outperform is still there as long as the active manager has a rigorous process and their fees are not exorbitant.”
And what would happen if everyone invested in the Russell 3000? Ben Kumar, investment manager at Seven Investment Management, points out that there are more indices than there are stocks.
“If ETFs all tracked the same index, then sure, there’d be a big wall of money forcing markets into a non-discriminating state of inefficiency,” he says. “As it is though, I can build hundreds of portfolios using ETFs, with very little similarity between them all.”
Vanguard’s Bartolacci adds that in terms of total dollar value, indexed assets only makes up 15% of the global equity market, and bonds just 5%.
“We are a long way off from the market reaching a tipping point. In addition, the price setting mechanisms are still that of active traders, hedge funds or even retail investors,” he says.
Assets in fixed income ETFs have even further to go. As of March 2018, the total global amount of fixed income issuance stands at approximately $96trn, and less than 1% of that, around $790bn, is in fixed income ETFs, according to Bluefin.
“The ETF market would have to grow 100 times or more with no further bond issuance [for fixed income ETFs to overtake the broader market] and that’s simply not going to happen,” says McGhee. The biggest institutions and pension funds generally only hold a small proportion of their assets in ETFs, he adds.
“Bigger pension funds will only really use ETFs that give access to more difficult areas of fixed income: for example, they might well use a high-yield ETF in a small proportion,” says McGhee. “Smaller pension funds use ETFs across the board.”
ETFs are not as liquid as their underlying securities
There are several important examples where ETFs have continued to provide liquidity and price discovery during times of uncertainty.
In the summer of 2015, the Athens stock exchange suspended trading for several weeks during domestic volatility. While the Lyxor UCITS ETF FTSE Athex 20 (GRE) temporarily shut its doors, its US-listed counterpart continued to trade. The same year, more than 14,000 Chinese companies suspended trading to stem panic selling by retail investors, but China-focused ETFs continued to trade. And following the Brexit referendum, several actively managed property funds halted redemptions while property ETFs, which replicate equity-based real estate investment trusts, remained open.
“We now live in very efficient markets with a lot of ways to move asset class bets around,” explains Nadig. “If everyone wants out of, say, junk bonds on a Tuesday at 2pm, they will sell the heck out of everything related to junk bonds. ETFs will go down. Options on ETFs will go down. Actual underlying bonds will sell off. There’s no magic to this.”
The price of the ETF is designed never to stray too far from net asset value of its underlying securities, due to competition between market makers. This contrasts to investment trusts, many of which trade on wide discounts or premiums.
“Ultimately, ETFs can never be more liquid than the underlying market they track because creation/redemption activity is strictly delimited by the depth and size of the underlying market,” says Bioy. “However, by virtue of their exchange-traded nature, ETFs do bring an extra layer of liquidity to the marketplace. We’ve seen that in the high-yield bond space.”
Synthetic ETFs hold nothing
Since the International Monetary Fund, the Bank for International Settlements and the Financial Stability Board all claimed after 2010 that synthetic ETFs were riddled with “complexity and opacity”, the number of synthetic ETFs has dwindled. Assets in synthetic ETFs have dropped from 46% of overall ETF assets in 2009 to 20% in 2018, according to Morningstar.
“The war between physical and synthetic in Europe is over. Physical has won, but there are some countries where investors have a sophisticated knowledge of derivatives and they are comfortable with synthetic products,” says McGhee. “As a liquidity provider we prefer physical products, as we execute the bond hedges ourselves and can make investors tighter prices on the ETF.”
While there are fewer synthetic products today, there are still myths about the remaining ETFs today, such as the ETF “holds nothing”.
“This is not true. The bulk of swap-based ETFs in Europe hold a basket of highly liquid equities or bonds,” says Bioy. “Should the swap counterparty go under the fund has immediate access to the basket of securities, which can be sold if needed.”
McGhee adds: “There are strict rules about how synthetic ETFs are structured as the type of collateral used is governed by UCITS regulation. Sometimes swap-backed ETFs are the only way to give investors access to a foreign market. Saudi Arabian equity exposure is a good example.”
ETFs carry out too much securities lending
Securities lending, whereby the fund manager loans out a proportion of its portfolio in exchange for collateral to enhance returns, is not exclusive to ETFs. It’s a common practice across the investment management industry carried out by mutual funds, pension funds and other vehicles, according to Bioy.
“Passive funds have lower turnover than actively managed funds and hence are less subject to the risk that the fund manager will recall the loaned securities,” she says.
ETFs are more transparent about their securities lending activity than other types of funds, Bioy adds
“They disclose information on their websites, including average and maximum on-loan levels, collateral composition, collateralisation level, and net return on a fund by fund basis,” she says. “The same couldn’t be said about actively managed funds.”
Most ETF providers limit the amount of assets that their funds can lend out at any point in time to 50% or less, while iShares ETFs can lend up to 100%. Some providers, such as UBS, have decided to exclude fixed income ETFs and ETFs that focus on environmental, social and governance aspects from their lending programme. Other providers don’t lend securities at all, while Vanguard only started allowing securities lending on its equity ETFs from November 2016.
“Securities lending is a very important aspect of the marketplace as it increases the liquidity of the underlying securities and improves market efficiency and lowers costs,” says Bartolacci. “At Vanguard we take a very risk-controlled approach and 100% of the revenues, minus the cost of running the programme, go back into the fund and benefit the end investor.”
Morningstar’s latest survey on the subject was in 2013, which found that around two-thirds of physical ETFs lent fewer than 20% of their assets on average and that 50% lent fewer than 10%.
“I suspect the amounts on loan have since declined partly because of withholding tax harmonisation in Europe,” says Bioy.
Figures from IHS Markit’s latest quarterly review found that 88% of securities lending revenue within ETFs comes from US-listed funds. It showed that US ETFs had an average value on loan between April and June of $39bn (€33bn) while Europe only lent out an average of $4.6bn (€3.9bn).
“Securities lending may be the closest thing to a free lunch in investing,” says Nadig. “I recently did a ton of legwork trying to find a single example of a securities lending default that impacted regulated shareholders. I went back to 1980. I couldn’t find one, in funds or ETFs. If someone finds one, please tell me.”
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Implementation: Five myths about ETFs debunked