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Concerns ETFs could amplify the next market crash

A look at whether they could be a systemic risk or not.

Passive investing has grown exponentially over the past decade. According to independent research firm ETFGI, there was $5.4 trillion invested in exchange-traded funds (ETFs) and exchange-traded notes (ETNs) around the world at the end of April this year. This figure has grown at a compound annual rate of 27.1% over the last 10 years.

This shows that the way that many investors access stock and bond markets has fundamentally changed. The question this has raised for many observers is whether this has also fundamentally changed markets themselves.

Critics argue that the growing scale of ETFs poses a risk to how markets function, particularly when it comes to liquidity. This is because ETFs require the involvement of authorised participants – investment banks and trading firms that exchange ETF securities for the underlying stocks.

Some argue that in a market crash, a mass selling of ETFs when investors panic and ‘rush for the exits’ would cause a liquidity crisis. That is because there simply wouldn’t be enough participants willing and able to take the weight of that selling.

What’s the difference?

These arguments have gained a fair amount of traction in some quarters, however it’s difficult to see how they stand up to scrutiny. As Jason Xavier, head of EMEA ETF capital markets at Franklin Templeton, explains, ETFs are simply a vehicle to gain exposure to markets, just like mutual funds. And whether investors are buying or selling ETFs or mutual funds, the impact on the market is the same.

“The ultimate decision to buy or sell a security resides with the investor,” says Xavier. “Once that decision is made, how you gain that exposure is either through a mutual fund, buying a security directly, or through an ETF.

“If all participants make the same decision, that’s when markets go up or down. It has nothing to do with the wrapper being used.”

Importantly, because ETFs are open-ended and issuers can list more securities or cancel them as necessary, their liquidity is never separate from what they are investing in.

“The liquidity of the wrapper is a function of the liquidity of the underlying securities,” Xavier points out.

Wag the dog

ETFs also make up a relatively small part of any market. Even in the US, where passive investing has grown so popular, the assets held in ETFs are substantially lower than those in mutual funds.

“ETFs represent a very small component of the overall fund universe,” says Xavier. “They are around 5% of the European equity market, and 2% over the overall fixed income market. Even in the US they still only represent around 10%.”

It’s therefore difficult to argue that they could have any impact severe enough to overrule whatever is happening in the other 90% of the market.

That would be an exceptional case of the tail wagging the dog.

Some critics argue that they would have an outsized impact because authorised participants are not obliged to exchange ETFs for the underlying securities, and might be unwilling or unable to step in if the weight of ETF selling became too severe. However, Xavier does not see this is as a valid concern.

“Authorised participants are made up of investment banks and specialist trading firms,” he explains. “Those same banks, those same trading firms, are trading the underlying stocks or bonds for 90% of the market universe – they are responsible for buying or selling any single stock or bond for retail investors, institutions, mutual funds, and the whole ecosystem.”

“When we are talking about ETFs, we are discussing 10% of the market,” he adds. “If the concern is that there is something stopping them trading those ETFs, I would say let’s not worry about that 10%. I would worry about what’s happening in the rest of the world, because then there is a bigger issue.”

Understanding

Put another way, ETFs respond to the market, not the other way around. Intuitively, that has to be the case, since the nature of ETFs is to capture the performance of a market or market segment. They therefore can’t also be determining the thing that they are designed to reflect.

For Xavier, the concerns about the market risk posed by ETFs are therefore unfounded.

“It comes down to a lack of understanding of the product and a lack of education of what the product does and how it works,” Xavier believes. “We have many large institutions as clients that use ETFs. They have big departments that look at risk and liquidity, and make sure that they understand how the product works. They invest large sums of money.

“That should be confirmation that there are sophisticated investors who use this product and are very happy with how it works,” he says. “There has never been an example of a big institution saying that we have a serious problem with ETFs and we are no longer going to use them.”

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Food for thought. I think in SA the type of investors investing in ETF’s is mostly long term investors and not traders and most will not exit the market when it drops. In the US a lot of their ETF’s are traded daily that makes it a bit different.

I agree with the idea that the type of investor in SA that invests in ETF’s is fundamentally different to the investor that trades daily. ETF investors predominantly have a longer-term view (My opinion) and as such, is more unlikely to be affected by short-term volatility.

My opinion is that, in the event of a market sell-off, a number of investors will “run for the hills,” but this will not be due to the ETF’s effect, as an ETF’s main function is to track a benchmark, so the sell-off would occur either way.

Again, just my humble opinion.

Exactly right. Cannot wait for the prices of markets, etf’s etc to crash so that I can pile in and buy more.

The two opinions above are spot on in my opinion.
And remember what goes up must come down and vis a versa so, just like a traditional share, ETFs will survive in the long term.

There is a level of indirection that is not being taken account of.

EFTs track an index; indexes are made up of shares in specified ratios.

So if the price of the overall market drops… those specific ratios stay the same in the index… but their prices are only effected and therefore effect the price of the ETF… I don’t see a sellout storm.

Or am I missing the point here?

its the robo etf’s that will cause the sell off…just as the Black Scholes model did it in 1987

Still don’t see a problem here; even if all the ETFs in existence try and dump their shares… could make for a wonderful buying opportunity in the shares. 🙂

The following question provides the answer. Say we have VBS Bank as an active participant in the market. Some clown at VBS decides to use the entire asset base to build a 10X geared position in the locally listed S&P500 Index ETF called STX500. The next moment the market goes against him and he is forced to liquidate his position on the JSE. Will his selling pressure cause a decline in the value of the underlying, which is the actual S&P 500 Index in the USA? Of course not, his selling pressure may force the ETF to trade at a temporary discount to the underlying, but arbitrageurs will be quick to exploit that risk-free opportunity.

Many hedge funds, banks and individual speculators trade on margin. They will become forced sellers in the event of a sizable correction. The sheer volume of sales will put pressure on the value of the ETF, but that will dissipate through to the underlying instruments.

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