The rise of ETFs since the Global Financial Crash has been nothing short of extraordinary, however, it has not come without its critics.
While criticisms have largely come from parts of the market ETFs are directly disrupting, for some investors there is still a question mark around the ETF wrapper, which has only seen its assets increase during this decade-long bull market, will cope during a serious market downturn.
The most recent person to weigh in with their warning about the dangers of ETFs was Michael Burry, who shot to fame for betting against the US housing market in the build-up to the GFC which was depicted in Michael Lewis’s book The Big Short.
Burry argued ETFs reminded him of the “bubble in synthetic asset-backed CDOs” before the GFC because price-setting “was not done by fundamental security-level analysis, but by massive capital flows”, adding “it will be ugly” when the flows into passives reverse.
The famed investor is not the first, and will certainly not be the last, to criticise ETFs. In 2016, Alliance Bernstein analyst Inigo Fraser-Jenkins in 2016 describing ETFs as “worse than Marxism”, given that communists attempted to allocate capital efficiently, while in 2018, Neil Woodford said the “gigantic inflows into smart beta ETFs” was one his flashing red lights suggesting the market is in bubble territory.
One key point to make is indexed products – ETFs or index funds – in stocks and bonds make-up less than 5% of global assets. To argue a big withdrawal from these products will cause a market crash when they total such a small proportion of the overall investment landscape should be seen as an exaggeration.
Furthermore, while the majority of passive flows go into market cap weighted products, there are also ETFs for a whole variety of market exposures such as sectors and factor tilts meaning not all assets are going into the same underlying securities.
Perhaps more seriously, regulators have also issued warnings about the potential for ETFs to cause systemic risk.
The area they continue to highlight is the role of authorised participants (APs). Last year, the European Central Bank (ECB) warned liquidity risks in the primary and secondary ETF market have the potential to amplify risks in the financial system.
This was further backed by the European Systemic Risk Board (ESRB) in June, who argued APs could simply not enter the market to create or redeem ETFs during periods of market stress.
Marco Pagano, chair of the ESRB’s Advisory Scientific Committee, said: “APs engage in the creation and redemption of ETF shares in pursuit of profit and have no commitment to ETF sponsors or investors. Therefore, in stressed conditions, APs could simply decide not to engage in ETF redemptions.”
These warnings have been met by rebuttals from APs such as Jane Street who argue market makers are incentivised to remain in the market during periods of market stress so they can profit when flows become two-sided.
Perhaps the most encouraging development on this topic came in August when the Financial Conduct Authority (FCA) released a research note finding more APs entered the market to take on extra redemptions during periods of evaporating liquidity.
During the most recent volatile event, the US Presidential election, where primary market redemptions exceeded unit creation, the FCA found APs, who were normally less active, entered the market to provide liquidity.
At the time, Matteo Aquilinia, manager in the FCA Economics Department, commented: “[This initial research] shows preliminary evidence for alternative liquidity providers being willing to step in during times of market stress. Beyond these reassuring results, the analysis does not detect any initial signs of concern to financial stability.”
It is worth noting, even if all the APs did disappear from the market (which would not happen), for over 95% of ETFs, provisions in prospectuses allow the issuer to create a market enabling investors to exit.
In fact, the creation-redemption process is what makes the ETF wrapper more efficient than a mutual fund as they are not created using cash. This creation mechanism means the ETF issuer is not a forced seller as there is no cash involved in the transaction and does not have to suspend trading on the product as we have seen recently with Woodford, H20 and GAM.
There is no doubt the sceptics will continue to voice their concerns about the dangers of ETFs and it is likely it will take a crash for the wider industry to realise ETFs do not directly amplify risks in the financial market. It is vital to remember that ETFs are just a wrapper that enables investors to slice and dice the investment landscape in different ways.