Myth-buster: Will ETFs cause the next crash?

by , 1st February 2018

On the basis that what goes up must come down, predictions for what might cause the next stock market crash have multiplied even as the S&P 500 has reached new highs and volatility has all but disappeared.

Taking what might be said to be a two plus two must equal five approach, many commentators have hit upon the rise in recent years of passive investing, either through index funds or ETFs, and have suggested they will play a part in the next market downfall.

The list of people who have lined up to warn the world of the dangers posed by the rise of ETFs is quite impressive; they are headed by – in popular investment terms – Neil Woodford, the doyen of UK value investment who signalled at the end of the year that he viewed the “gigantic inflows into smart beta ETFs” as one of his flashing red lights suggesting we were in a bubble.

Systemic worries

More seriously, perhaps, views have been expressed by various regulatory bodies in the past suggesting that synthetic ETFs do pose a risk to the financial system.

Back in 2011, the Financial Stability Board suggested that swap-based ETFs may not be as liquid as would be hoped in times of stress. Said the FSB: “One of the things you expect from collateral is for it to be reasonably liquid for the exchange traded fund provider to meet redemptions if they occur – but there are some signs that this may not always be the case.”

The FSB added it was also worried about the plainer ETFs when it came to securities lending, suggesting a cap might be an option. But in general, the FSB’s words were more in the spirit of enquiry than consisting of any warning of a potential threat to the financial system. “Further study (would) be useful for assessing the potential impact of heavy ETF trading on the liquidity and the price dynamics of the referenced securities, particularly if they do not have an active secondary market.”

The European Securities and Markets Authority (ESMA) followed up with its own suggestions for the regulation of ETFs later in 2011 when it said that “it may be necessary for ESMA to issue warnings to retail investors about the risk posed by (ETFs).” Again, maybe something of an amber light, but hardly the stuff of investor nightmares

Such warnings very much focused on counter-party risk but notably, not much has been said in subsequent years.

I can’t go on, I’ll go on

There is an element of the prophecies of Cassandra about the persistent warnings from the regulators. Having been caught flat-footed by the 2008 financial crisis, they really don’t want to be seen to have been asleep at the wheel once again. Hence, the slew of warnings.

Bu the wilder claims from other quarters really have to be questioned. Woodford Funds issued a warning about various threats to the apparently benign market conditions at the end of last year which included the following about smart beta:

“The growth in ETF investing in recent years is astonishing, and within it, smart beta strategies are perhaps the most worrying. These quantitative, ‘factor-based’ investment strategies have attracted over $600bn in assets in a very short space of time, but nobody yet knows how these factors will perform in a market downturn. This isn’t really passive investing at all but do investors know what they’ve bought?”

The obvious response is yes, they do. No one – absolutely no one – is selling smart beta to investors in the way that Woodford intimates here.

This type of vague portent of doom foretold is prevalent among many of the attacks on ETFs, with some apparently taking a dislike to them on the basis that, like some of the products that have since been pinned with contributing to the last crisis, they feature a three-letter acronym.

None of which is to suggest that investors in ETFs won’t suffer as much as any other investor should equity markets crash.

The nature of the current bull market has driven commentators to look for what might cause the next crash. It is testament to the amounts that have been invested in ETFs over the past five years or more that they have alighted on the sector as a potential flash point.

But as yet there is no evidence that investing in ETFs is any more unstable than investing in mutual funds. Neither should be pinned with the blame should the markets falter later this year or next. In any rush for the exits, particularly with equities, then all participants will be treated the same whether they are active or passive.