The FT has, whether inadvertently or not, added to the ongoing debate on where the next downturn is coming from with two articles on exchange traded funds in the last day. The first was on the use of these funds in the USA, and noted that:
Record-breaking inflows into exchange traded funds this year are fuelling fears that the tide of money surging into passive investment is helping to inflate a bubble in the US stock market.
Demand for ETFs has accelerated sharply this year, as a growing number of investors move into low-cost funds that track an index, and out of traditional actively managed funds in protest at inconsistent performance and high fees.
A particular quirk on the sue of these funds in Japan was also noted:
Last week ... the BoJ unleashed a test launch of ... a record-breaking grab of more than $2bn of Japanese equity ETFs in 52 hours. That adds to a BoJ share portfolio whose book value passed $127bn at the end of June and is on track to envelop 3.2 per cent of the Tokyo Stock Exchange's market cap, according to forecasts for June 2018.
Instinct suggests that being the only developed market central bank to buy equities at this astronomical volume will have consequences; evidence suggests that is already happening. Apart from damping the downside when an apocalyptic soundtrack is playing, the BoJ's $30bn ETF spree in 2015 made that the first year since 1989 that the N225 posted a net gain for the year despite foreign investors being net sellers.
First, a quick note on what ETF's are: as Investopedia says of these funds:
An ETF, or exchange-traded fund, is a marketable security that tracks an index, a commodity, bonds, or a basket of assets like an index fund. Unlike mutual funds, an ETF trades like a common stock on a stock exchange. ETFs experience price changes throughout the day as they are bought and sold. ETFs typically have higher daily liquidity and lower fees than mutual fund shares, making them an attractive alternative for individual investors.
In other words, ETFs are quoted funds that are in effect tracker funds of other quoted investments. So what's the issue? There are two.
The first is the folly of the Bank of Japan: QE may have a role buying government bonds (although even that can be questioned unless the funds are used to create new asset investment) but it definitely has none in my view in buying corporate bonds, let alone shares. This is just market game playing and I cannot see any role for a central bank in doing that. The BoJ position is artificial and distortionary as a result and I can see no benefit from that.
The second is broader, and is a liquidity issue. If there is a run on these funds in the event of a stock market downturn I can see them adding to liquidity pressure as they effectively leverage the underlying assets by double quoting them. This could ratchet a downturn in market sentiment and add to instability, effectively reflecting the burst of a double bubble. Anything that can do that is dangerous. The fact that ETFs have had a good track record simply says they have reflected the market recovery (as opposed to the real market recovery) from 2008. Nothing suggests that they add real value, and I strongly suspect that in a period of instability they would do the exact opposite.
I share the FT's concerns.
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Very well put. Blindingly obvious.More than impressed. Thank you
Assuming that you are talking about ETFs which are backed by physical assets (i.e. they buy the actual shares within an index to replicate that index’s returns), then you are incorrect in a number of ways:
1) The ETF’s do not represent double counting of the holdings (The ETF’s are merely shareholders in the company in the same manner as any individual holder, or actively managed fund, would be)
2) ETF’s add real value because they are a viable (and cheaper) alternative to investing with an active fund manager, the majority of which do not out-perform an index (and typically charge management fees which are multiples of the underlying management cost of ETFs, an area you have highlighted in the past)
3) ETF’s have absolutely reflected the real market recovery because they are direct holders of the shares which have risen in value in that market recovery.
You may however be inadvertently correct that they could be a destabilising factor, but not for the reasons you have stated. Their success has made them huge holders of shares across the globe, and it is therefore their size which is the problem, rather than any deficiency in the manner in which they invest or reflect the value of the underlying holdings.
But one also has to remember that the vast majority of ETF’s are not ‘actively’ managed, and any sales they therefore make (aside from their rebalancing to reflect the rebalancing of an index) will only be in response to a sale instruction from an underlying holder, and therefore the sale they undertake in the market will therefore replace a disposal a client was making if they were a direct shareholder (One could argue that the sales by ETFs were actually less destabilising, as the sales will be small ones from across each of the fund’s underlying holdings, rather than a single share being hammered by large scale, concentrated selling)
I disagree: exactly the same could have been said of CDOs, SIVs, etc. The reality was they created an impression of liquidity that was not actually there. I think ETFs can easily do the same and if there was a run on the ETF market disruption might follow
Sorry, but ETFs have no effect on liquidity risk. It matters not a hot whether the underling shares are held in a mutual fund, an ETF or any other way the liquidity risk is the same. Creating an ETF doesn’t create More liquidity risk because it can always be liquidated, in which case it is the risk of the underlying shares, which hasn’t changed.
Ah yes, they can always be liquidated
That’s what’s always said
Until they can’t be of course
Which is exactly what the liquidity crisis I am talking about is
And which you are denying could happen
But which will, nonetheless
If only more people just wrote from the heart rather than researching a topic before writing about it. But sadly Punam is correct
And I disagree
And I have looked at such issues for a long time – from the perspective that spots the risk
With all due respect, you may have looked at synthetic instruments such as CDO’s / SIV’s etc in the past and deduced, probably correctly, that they exacerbate market crashes, but in this instance, and again, using the caveat that you are talking about ETFs which buy physical assets, you are incorrect. An ETF is effectively a collection of shareholdings of multiple investors. Other than for reasons of rebalancing to reflect an index change, the only reason an ETF would sell shares would be if they had received a liquidation order from a shareholder. Whether the underlying shareholdings are sold by the ETF, or (in the event they had chosen to buy the shares themselves, rather than invest in the ETF) the shareholder directly, the effect is the same.
What you seem to be imagining is that the ETF’s all go for the door at the same time and struggle to sell their share holdings. That could only happen if investors in the ETFs are liquidating their holdings in the ETF’s, which would have exactly the same outcome as if those same shareholders were selling the underlying shares themselves.
That is not to say that illiquidity problems could not result because of all investors rushing to sell at the same time, but the existence of ETFs would not have exacerbated the problem.
See my reply to Graeme
I am sure you have given much thought to this difficult subject, much more than an amateur like me, but I would really be grateful if you could find the time to explain the difference between an ETF buying a share in Glaxo and me buying a share in Glaxo. It is puzzling me. An ETF holding a set of options to buy or sell Glaxo shares might be a different case.
It’s a trees and woods thing
If we look at a transaction you can argue that there is no difference. And IO am sure that’s what you’re doing
When we look at why the ETF does this – to make money – and how it does this – by bringing more money into the market – and what the consequence is – which is a market bubble right now but the presence of more volatile sellers in a down turn all of them working through secondary agencies that make these people feel stages removed from risk (this is so 2008) – then I’m afraid to say I think I’m right
It’s all a matter of perspective and I take the big picture view
I don’t see how a big picture view wouldn’t also encompass the landscape Punam describes but it may provide insights that candidly I lack.
Are unit trusts and OEICs potentially as hazardous as EFTs?
All funds that market investments that the purchaser may not fully understand carry that risk
As we have seen before
I’m sorry, are you seriously suggesting that an ETF would encourage somebody to invest in a market which they otherwise would not invest in ?
And that, having done so, that those buyers would be more likely to be ‘volatile’ sellers in a down turn, the implication being that they would be of a size to have an effect on the whole market’s liquidity ?
If you take the time to try and find the list of the largest holders the largest UK’s largest ETF, the IShares FTSE 100 Fund, you will see that there isn’t one single non-expert (or regulated) investor in the entire top 100 holders of the fund, and therefore not one that would feel ‘stages removed from the inherent risk’ of investing in the ETF. The greatest users of ETFs are expert investors, not your imagined ‘naïve buyers’, and certainly not ones that would be of a size to have an effect on a market’s liquidity.
You may ‘think you are right’ but hopefully you will accept that the evidence would suggest otherwise.
Yes, I think those things
That’s why ETFs exist
And I do not believe in expert investors
Richard, I normally hang on your every word, but on this occasion, I think that Punam is more right than you are. If we stick to ETFs that hold the underlying shares, surely the problem is volatility, rather than liquidity?
If most of the shares in an index are held passively, then I would expect the random actions of the smaller number of active (≠expert) investors to be magnified. Not welcome, but how big a problem is it?
Looking further through the trees, I certainly expect a market crash within a few years and some companies to go out of busines. But I don’t expect every company to go out of business, so that the ETF should still be worth something. If most of the companies are still there, and still paying dividends, then the index will recover to a rational level
It is worth remembering how the tech crash of 2000 was far less serious than 2008.
A criticism of a Market Cap weighted index will be that it will always be overweight in overrated shares and underweight in underrated shares. In principle, the amateur investor should do better by picking shares with a pin, but I have never dared put this into practice. However, I have had good experience with alternatively weighted ETFs.
I think you miss my point: I believe these vehicles over weight the market and that creates risk that will not always be appreciated
At a micro level you are right
But then at that level rating agencies were right on mortgage backed SIVs
Good article and you’re correct Richard. In the not so distant past ETFs were tied closely to an underlying basket of stocks or a meaningful index. Now there are many such products which reference synthetic assets and inflows have sometimes dwarfed the underlying. And then there are leveraged ETFs.
And what the FT has explored on other occasions is the manner in which liquidity is created – there are dealers in the middle who create “creation units” which are held by investors as proxy for the issuer’s holdings. Totally similar to SIVs, CDOs and other financial engineering.
There is also a broader point which hedge fund managers and other have seized on – while on the one hand they are sore at losing inflows to lower fee ETFs they nevertheless point out that if everyone indexes then capital markets cease to be efficient (as no-one is bothering to actually allocate capital, just follow an index).
A good example of lazy investors repeatedly putting money into a value destroying proposition is Dryships shares – a notorious swindle of late.
Agreed
There are such fascinating exchanges on this thread but I have to note that I am still befuddled.
It is a rare quality to admit this but the lack of material wealth to participate in the markets doesn’t prevent me from taking an active interest.
Where, Richard, should the conscientious person seek to place their modest savings after a lifetime spent as a teacher (in an obscure prep school) in order to cause least harm?
Gilts
And if you are very risk averse cash right now
This is nit investment advice
It’s least harm advice
This is very depressing news since this will mean a negative return in real terms.
Surely even the most enlightened saver – and I’d like to think we both are, though I’m obviously not in your league – can be forgiven for looking to unit trusts etc. to provide for that rainy day when our health or mental faculties fail.
I’ll cover that this morning
[…] beliefs are irrational. That is why I think a downturn is inevitable. And why I think anything that lures more people into the market than is wise is dangerous for the liquidity crisis to come when people will try to exit markets […]
Exchange Traded Funds exacerbate the markets’ volatility and liquidity risk; these risk-magnifiers are intrinsic to index-trackers in general, with some interesting extras rising from the special features of an ETF.
I’ll confine myself to equities here, because they are easiest to explain; and, as a declaration of interest, because they are easy for me to write about, having written live market pricing and order-management systems for equity index ETFs.
The volatility point is intrinsic to all tracking strategies: when a stock or a sector is rising, for whatever reason –
good, bad, or none – trackers will pile in with the general ‘buy’ momentum: so this momentum becomes even more pronounced, and prolonged, and irrational.
Likewise, for a drop in price; trackers add momentum to the stampede.
Further: if a tracker fund can’t keep up – and liquidity matters here – it will always end up selling at a price below the intrinsic ‘basket’ value of its assets.
This becomes a double effect: the fund manager (or the automated order manager) is “Sell, Sell Sell!”, adding to the downward momentum; and the fund holders are liquidating as fast as they can forcing the fund manager to sell even faster.
Tracker funds are always exposed to an asset-specific liquidity squeeze, and dangerously exposed in a systemic liquidity crunch. They are forced to over-react, and their orders add to the liquidity problem.
…And then we come to the secondary effects of investors’ responses to the funds’ sudden inability to track and their intrinsic loss of value.
Now for the special feature of an ETF: it’s a two-sided instrument. One side faces the retail investors, who have exactly the same incentives as any mutual fund participant or unit trust holder; the other side faces professional investors in a way that forces the fund manager to be very efficient, and very, very disciplined in tracking the index precisely.
In simple terms, professional investors can buy units of an ETF and ‘break them up for spares’, instantly becoming holders of the component index assets.
That is to say: instantly becoming sellers of those assets.
So an ETF that’s underperforming – quoted at a price below the ‘break up’ value faces an immediate attack from ‘arb’ traders (or rather: arb trading algorithms) that reinforces their downward-tracking momentum, and piles on – hard! – in a bear market.
ETF managers can and do widen their buy-sell margins in adverse markets: but there are penalties for doing this – if you fail to maintain a quote and a defined maximum margin for too long, the exchanges withdraw their preferential ‘liquidity provider’ fees and this inevitably pushes the ETF into underperformance.
An ETF manager will grit their teeth and take the losses rather than risk that.
And, in a sustained bear market – or if one component of the basket is falling rapidly – widening your margins won’t protect you from professional ‘arbs’ and disgruntled retail investors.
ETF’s have a place – among other virtues, they are *forced* to be efficient in a far more direct way than other fund managers – but they are also forced into the vanguard of the systemic risks of a market with more trackers than rational players.
I am equally amused and disappointed by some of the responses you have received here, Richard: and your points about ‘missing the point’ – especially on liquidity and systemic effects – are both true and truer than you realise.
Thank you