Are ETFs destroying capital markets?

Ben Volkwyn, Head of Private Clients,
Cannon Asset Managers

Exchange Traded Funds, more popularly known as ETFs, have undergone exponential growth over the past 20 years without any signs of slowing, irrevocably changing the way in which investors interact with the market. According to Ernst & Young’s Global ETF Survey (2018), given their low-cost diversification benefits, the assets invested in ETFs have grown by about 630% over the last decade.

There are now at least 5,000 ETFs trading globally, ranging from the more traditional index, sector and industry or style-specific ETFs to the more exotic inverse, leveraged and tax-deferred ETFs.

Source: Cannon Asset Managers; Ernst and Young (2018)

However, while it is easy to get caught up in the fast growth of these increasingly popular instruments, their opponents argue that the meteoric market growth could pose a danger to capital markets and investors.

Liquidity concerns

Critics warn of the potential dangers resulting from a lack of liquidity in ETFs, especially in the event of a market crash or mass selloff in the asset class.

Before we address this specific risk, it is important to understand the mechanism by which ETFs are created. Effectively, ETFs are wrappers that enable you to buy and sell a basket of assets, such as the largest 500 companies listed on stock exchanges in the United States, an S&P500 ETF. Buying and selling of ETFs is facilitated by the fund being listed on stock exchanges, much like stocks. This allows individual investors to gain exposure to an array of assets or financial instruments through a single point of entry.

Authorised participants (usually investment banks and large trading houses) then make sure the underlying assets are held in the fund, while also regulating the supply of ETF shares in order to align their pricing more closely with the net asset value (NAV) of the underlying portfolio.

In contrast to stocks which have a limited number of shares available, the number of outstanding shares in an ETF can change daily owing to the continuous creation and redemption of shares by authorised participants.

Effectively this means that ETF structures derive their liquidity from their underlying assets, carrying the same liquidity risks as the underlying portfolio – which should be understood and considered before investing. A greater caution may, for instance, be placed on leveraged or derivative ETFs, but these pertain to the nature of the underlying assets, and not to the ETFs themselves.

However, given that ETFs are publicly traded, investors would be wise to be wary of ETFs that are very thinly traded and that have wide bid-offer spreads, which could have an unnecessary cost implication. Also, it is important to be aware that although ETFs generally track the underlying assets quite well, discrepancies do occur from time to time.

Indeed, these very discrepancies have led some to claim that ETFs may in fact boost market liquidity, as authorised participants profit by trading on price differences between ETFs and their underlying assets.

Historically, stocks have experienced a boost in demand and consequently excess price performance in the days immediately preceding their official addition to an index, while the anticipated removal of a share from an index would see its price fall – a phenomenon known as the “index effect”.

However, research on US markets by Anthony Renshaw, Director of Index Solutions at analytics provider Axiom, shows that the index effect has become substantially muted since 2013, coinciding with the rise of ETFs and passive investing.

Renshaw suggests that the two may be connected, as intensified trading activity by authorised participants hoping to seize the advantage of price discrepancies in the run-up to index changes may mute any sustained positive or negative price momentum, thus adding liquidity to the market.

Concentration and systemic risk

Another concern often raised is that passive investors continue to buy ETFs with little care for value, decoupling share price and performance from fundamentals and heightening the potential impact of a market correction, leaving investors more susceptible to the effects of a market crash.

Additionally, as most equity indexes are weighted by market cap, critics argue that ETFs will continue to place undue emphasis on larger cap shares, raising the potential risk of ignoring the value to be found in mid- and small-cap shares.

But this is not a new phenomenon: for most of our investment history it has been shown that larger-cap shares are more efficiently priced than their smaller-cap counterparts. Furthermore, with the ETF ranges currently available, we now see all shapes and sizes of portfolio compositions.

However, as with all investments, it is worth emphasising that investors should buy ETFs when they show value, and not only buy blindly due to their low-cost structure. Investors need to ensure that their portfolios are balanced, taking valuation and cost into consideration.

It is worth noting that, despite their recent surge in popularity, ETFs represent only a small percentage of the investment universe, perhaps making dire warnings about their potential impact somewhat hyperbolic – especially as unit trusts and other collective investment schemes invest in many of the same assets.

Ultimately, although they are not without risks, ETFs are a great addition to investment markets – especially funds that include gearing and derivative instruments. And ETFs can add great value to any portfolio, whether as a core or satellite component.

The key is to be aware of their potential disadvantages or pitfalls, and, as with any investment vehicle, to select wisely, putting risk and valuation at the head of any investment decision.