How market volatility is set to stress ETF structures

2019’s uncertain financial outlook is causing discomfort among many financial market players. For some, ETFs lie close to the heart of this malaise.

For over a decade exchange-traded funds and other passive investment products have been a hit with institutional and (increasingly) retail investors across the globe. ETFs, in particular, offer a tempting mix of qualities: trading flexibility and portfolio diversification at costs far lower than actively managed mutual funds.

That combination has supported rapid growth. ETFs and exchange-traded products (ETPs) had total assets of $3.55 trillion at the end of 2016, but by October 2018 this had swelled to $4.94 trillion, according to data from ETF consultancy ETFGI.

Similarly, net new assets invested into Asia-Pacific ex-Japan ETFs and ETPs reached $2.87 billion in September and $18.97 billion year-to-date. Regionally listed ETFs and ETPs enjoyed 11 straight months of net inflows. Investors have clearly been keen on these low-cost products.

Janet Li, wealth business leader for Asia at Mercer, said: “Generally seeking alpha is not easy, so coupled with the fact there are many more innovative ETFs being launched in the market, that definitely has provided some good alternatives for asset owners to choose from.”

But not all ETFs are created equal. Some of the products could come under severe stress during market wrenches, which could cause pitfalls for those not looking closely, warns Kristian Fok, chief investment officer at Construction and Building Unions Superannuation.

“We would be careful around some of the ETF instruments – not so much the ones that are backed by listed and liquid underlying securities, but the ones where there’s a mismatch, those that invest in less-liquid strategies,” Fok told AsianInvestor.

DISLOCATION RISKS

The biggest issue at hand with ETFs is that while demand for them is growing fast, many investors don’t fully grasp how they operate.

“Limited is probably the most polite word; most people I talk to in Asia do not know what an ETF is,” said Tariq Dennison, director of ETFs and pension portfolios at GFM Asset Management.

The product itself is essentially a share, which means it is subject to stock market volatility, bid-ask spreads, market momentum, and asset flows. However, the ETF is also meant to reflect the value of its underlying assets.

While market cap-linked ETFs are the most popular, a growing number are quite different. They include synthetic and leveraged ETFs that offer exposure to alternative index metrics, such as momentum or volatility management strategies.

Of the 7,616 ETF products in the market as of October 2018, 3,632 are smart beta, fixed income, leveraged and inverse, and crypto-based products, accounting for about 34% of total assets under management, according to ETFGI.

When markets are rising, ETFs flourish. But periods of market stress can strain ETFs, as the product needs to provide enough liquidity to trade but it also needs to try and mirror the performance of the underlying assets.

“One of the key things that investors aren’t necessarily aware of is … there will be big price discrepancies between the [ETF’s] bid-ask spread in a time of crisis, where the underlying asset is not tradeable,” Joel Coverdale, head of Asia-Pacific at risk consultancy Axioma, told AsianInvestor.

Essentially the value of the ETF itself can become unhinged from that of its underlying assets. That dislocation can cause additional risk concerns for investors.

“When we invest in a global book of securities, all the individual stocks or the portfolio in aggregate will be subject to [the same market] volatility. But ETFs require market makers and there is a bid-ask spread involved, so from our perspective it’s an additional layer of risk for institutional clients to consider,” Li said.

Additionally, at some point, ETF market makers need to deliver the underlying basket of securities. That’s not a problem in normal markets, but during times of market stress, the market maker or ETF provider may decide the underlying assets aren’t tradable, and thus price the product at a level that they consider to be a fair market price.

Of course, that price might fall well short of where investors think it should be.

“In times of stress, clearly the demand/supply dynamic of the ETF itself could drive the price away from the underlying. It isn’t necessarily hard to sell, just hard to sell at a price that the investor may want to receive,” Coverdale said.

GROWING COMPLEXITY

Investors don’t necessarily realise how many different moving parts there are in the creation and redemption process, or that risk and the availability of trading liquidity in ETFs can shift unexpectedly during periods of market stress.

“As an institutional investor, you’ve got to be very careful about what you’re doing and where you’re investing these things because, at a time of crisis, the worst situation is going to become apparent,” Coverdale said.

That ignorance is a growing concern, given that the ETF market continues to expand and increasingly complex products are proliferating.

“The problem with ETFs is that the market continues to grow and, as an industry, they’re looking for how to launch new products to gain market exposure, and those tend to be more esoteric and more difficult-to-verify products,” Coverdale added.

The more esoteric an ETF gets, the more the unexpected can occur. A recent example took place on February 6, 2018, when the Cboe Vix index – which measures stock volatility based on S&P 500 index options – spiked upwards to 37.32. The rise caused an exchange-traded note from Credit Suisse that inversely tracked the index to lose 96.3% of its value.

“We saw this with the Vix ETF, whereby there’s a layered risk associated with the fact that [the ETF is] leveraged and they’re not trading something that fundamentally is an asset that’s normally used for trading,” said Coverdale.

A poor grasp of how ETFs work can lead investors to take risks that are way too concentrated or to use too much leverage to try and achieve their return goals.

GFM Asset Management’s Dennison added:  “Whenever you have a case like [Vix ETFs], people see that this thing’s been doing really well lately, and then they’ll buy it without fully understanding what they’re buying.”

ETFs can also be a bewildering asset class for the uninitiated. Rebecca Sin, head of ETF sales and trading for Asia Pacific at Commerzbank, said there are almost 6,000 products globally, That variety can overwhelm retail and even institutional investors.

“With the immense selection of ETFs available today, the biggest risk for investors is not understanding exactly what they have invested into,” she said.

Some investors select ETFs based purely on management fee and AUM, without considering the total cost of ownership, which includes trading cost, tax implications, and bid-ask spreads.

“At the moment there’s very little transparency and many products that are named quite equivalently in the market have very different portfolio construction rules,” Coverdale said.

This article was adapted from the cover story of the December 2018/January 2019 edition of AsianInvestor.