ETFs: With Explosive Growth Comes Hidden Risks

This article was originally published in Arab Times

The global market for exchange-traded funds, or ETFs, has doubled in size in just four years to nearly US$1.5 trillion in assets today. BlackRock, State Street Global Advisors and Vanguard lead the market with a combined share of roughly 84% of ETF assets. Equity products dominate the scene and geographically the US and Europe account for the lion’s share of the market. Amidst this exponential growth and following an earlier article in the Financial Times (FTfm supplement) Dave Larrabee, Director of member and corporate products at CFA Institute, and Mandagolathur Raghu, President of CFA Kuwait, evaluate whether investors fully appreciate some of the risks associated with ETFs and their impact on the GCC region.

How can ETF’s develop local markets?

The development of ETF products can attract institutional investors, especially foreign investors, and can thus help deepen the local market. It will also enable the floatation of specialized products aimed at wealth preservation and volatility management.

Why are ETF’s not popular in the GCC?

In general, ETF’s have thrived in deep and liquid markets. Consequently, the poor and decreasing liquidity of GCC markets has had an impact on the evolution of ETFs in the region. Also, the development of ETF markets require active institutional investor participation which is generally lacking in the GCC since their markets are predominantly retail driven.

What is behind the popularity of ETFs?

The popularity of ETFs with investors is attributable to the ease with which they can be bought and sold, their tax efficiency, low cost and their ability to provide broad diversification within an asset class, sector or geographic region. ETFs trade throughout the day like stocks and like stocks can be shorted and purchased on margin. ETFs are generally more tax efficient than mutual funds, though they still pay out dividends and gains arising from changes in the underlying indices they track. While mutual fund redemption requests can force fund managers to sell stocks and incur capital gains that are then passed along to shareholders, with ETFs, the underlying portfolio remains the same when an investor buys or sells shares.

The versatility of ETFs has made them especially popular with financial advisors and individual investors. ETF sponsors have capitalized on the demand for ETF products by aggressively expanding their offerings. The development of more exotic types of ETFs, including leveraged, inverse and synthetic ETFs, have brought greater complexity to the market, and investors may not fully understand the risks embedded in these products.

What are the principal risks associated with ETFs?

The degree of risk ETF investors face varies depending on factors like the type of ETF, the fund strategy, the nature of the underlying assets and the fund sponsor. Risks can include tracking error risk, counterparty risk, collateral risk and currency risk. Most of the focus of late has been on risks associated with some of the more exotic versions of ETFs, including leveraged, inverse and synthetic funds. Most leveraged and inverse ETFs are designed to deliver a multiple of the daily underlying index return using swaps, futures and other derivatives. Over longer periods of time, volatility erodes the returns that short-term oriented funds like these are designed to deliver, often resulting in large performance differences between the ETF and its underlying index.

Synthetic ETFs, which are popular in both Europe in Asia, attempt to replicate an index using asset swaps with counterparties. The sponsor then often backs the synthetic ETF with often lower quality, less liquid collateral that does not match the underlying assets. An ETF forced to liquidate assets could easily find that its collateral is suddenly worth much less.

Are ETFs responsible for increased market volatility?

While synthetic, leveraged and inverse ETFs account for a relatively small portion of industry assets, they may have an oversized impact when it comes to contributing to market volatility. The G20’s Financial Stability Board, The International Monetary Fund, and the Bank of International Settlements have each cited synthetic ETFs as potential threats to global financial stability. Critics of leveraged and inverse ETFs say they can artificially magnify sell-offs and also create short squeezes, and this systemic risk was noted in a 2010 report by the Kauffman Foundation. Whether recent market volatility can be definitively attributed to the growth of ETFs, or the use of specific ETF products, is still being studied and debated.

Are there any important regulatory concerns or issues facing ETFs?

Increased market volatility, including the “Flash Crash” of May 2010, when the Dow Jones Industrial Average fell nearly 1,000 points in just minutes, put the regulatory spotlight on ETFs, along with high frequency trading. And the 2011 UBS rogue trading scandal involving allegedly fictitious ETF trading has heightened the scrutiny of lawmakers. The absence of over the counter (OTC) trade reporting requirements in Europe, where 60% of ETF trades take place OTC, have raised transparency concerns.

The U.S. Securities and Exchange Commission is reportedly investigating leveraged ETFs and their impact on market volatility. And the European Securities and Markets Authority has called for tighter regulations and recommended greater transparency and disclosure regarding the risks posed by ETFs.

What Are the Key Takeaways for Investors?

ETFs offer investors diversification and tax efficiency at a comparatively low cost, and strong investor demand has driven dramatic industry growth. In their more exotic forms, however, ETFs can bring unintended and excessive risk to portfolios. Accordingly, it is critical that they be analysed carefully and used judiciously by investors.

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