ETFs: The Systemic Risk Compass

“The factor that worries me most is an ETF offering an investor unintended exposures of their portfolio.” — Ashley Cooke, head of ESG options and passive, institutional consumer protection, DWS Xtrackers

“Accelerated occasions to the draw back . . . are usually not distinctive to ETFs. It’s any kind of concentrated funding. When individuals hit the exit button, the pace of buying and selling, as fabulous as it’s, it doesn’t give us time to suppose.” — Ed Coughlin, director of buying and selling companies, NASDAQ

“The query is whether or not the ETF will both trigger or exacerbate a inventory market panic or crash, whether or not it’s going to contribute to the pace of contagion.” — Kurt Schacht, CFA, managing director, Requirements and Advocacy, CFA Institute; member, The Systemic Risk Council

“We received snug with liquidity by speaking to a few of the ETF market makers about how they function, how they hedge, and make markets on these.” — Wen-Fu Wu, managing director, head of asset allocation and portfolio building, Basic Account portfolio, TIAA

Do exchange-traded funds (ETFs) pose systemic threat? Or are such issues exaggerated?

These questions have come more and more to the fore during the last a number of years. It’s not laborious to see why: It’s been greater than 10 years because the outbreak of the worldwide monetary disaster (GFC), and the present bull market, the longest ever recorded, is, protected to say, in late-cycle territory.

This mix of concern over the subsequent downturn — what may set it off, unfold it, or push it into extreme disaster territory — and large inflows into ETFs has led some, Moody’s Investors Service and Michael Burry, of The Huge Quick fame, amongst them, to sound the alarm.

With these points in thoughts, CFA Society New York, with assist from CFA Institute, convened a panel of ETF consultants. Representatives from all factors of the ETF trade compass — institutional and personal wealth buyers in ETFs, ETF issuers, market makers, and exchanges — shared their insights with tutorial researchers about ETFs and their related dangers. Entrance of thoughts on this dialogue was the query of what’s and isn’t an ETF, in addition to whether or not there’s something distinctive to ETFs that makes their dangers distinct in kind and magnitude from these of different securities.

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Jayesh Bhansali, CFA, of the Gabelli Faculty of Enterprise at Fordham College, who chaired the panel, described the present ETF panorama in his opening remarks:

“ETFs have grown considerably in measurement, variety, scope, complexity and market significance in recent times. Despite the fact that they nonetheless account for a comparatively small portion of the overall market cap, about 10% to 12% I recall based on a recent study, nonetheless, the common buying and selling quantity is north of 30%, which is comparatively a fairly large quantity.

“Whereas most ETFs observe liquid fairness indexes, one in all their key options is expounded to the capability to additionally replicate baskets of much less liquid property and kind extra liquid tradable surrogates. However as everyone knows, this so-called magical liquidity transformation has an incredible friction price hooked up to it.”

He went on to cite from a Moody’s report:

“‘The ETF market has grown quickly throughout a interval of relative calm, that means that it has but to be examined by a interval of excessive market misery or volatility. Sudden market liquidity shortfalls might be most pronounced with an ETF monitoring inherently much less liquid markets corresponding to high-yield credit score.’

“The report additional provides, ‘These ETF-specific dangers, when coupled with an exogenous system-wide shock, may, in flip, amplify systemic threat.’

“Therefore,” Bhansali concluded, “the importance of this matter.”

What Is (And Isn’t) an ETF?

To grasp their dangers, we first have to know what ETFs are. Funding funds composed of systematically chosen securities that commerce on exchanges doesn’t actually describe the ETF universe in all its nuance. Certainly, there are shocking data gaps among the many basic public and even inside the finance sector about what these securities are.

“The place individuals get confused generally is after they consider ETFs as an asset class,” stated Samantha Merwin, CFA, who leads public coverage efforts for iShares world markets at BlackRock. “ETFs are usually not an asset class. ETFs are an funding wrapper. They’re a software that enables buyers to entry the underlying asset courses.”

That sounds fairly easy. However there stays appreciable uncertainty and a few have advocated assigning the ETF label to doubtlessly questionable merchandise.

“One of many weaknesses within the trade is that there isn’t classification round what an ETF is and the way it sits within the market,” stated legendary ETF market maker Reggie Browne, principal of GTS. “I believe that’s a weak point that must be addressed. You could have people on the market advocating for bitcoin, diamonds, and different esoteric asset courses that don’t belong within the ETF trade.”

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Danger: Systemic and In any other case

To find out whether or not the dangers related to ETFs might be systemic in nature, the panelists additionally needed to outline what they meant by systemic threat.

Mark Hoffman, PhD, CFA, of PNC Monetary Providers Group and head of portfolio administration for PNC’s asset administration advisory companies, laid out an efficient working definition.

“What I take into consideration is materials, sustained, and widespread losses as a consequence of some kind of market breakdown,” he stated. “So if it’s one thing just like the Flash Crash the place it’s a matter of a few hours, or if it’s one thing that’s going to be reversed, or it’s sitting out in some esoteric market, we’re not serious about that as systemic threat per se.”

So what position may ETFs doubtlessly play in market downturns?

For perception on this, Ayan Bhattacharya, PhD, of Baruch School, Metropolis College of New York, who co-authored the CFA Institute Analysis Basis title ETFs and Systemic Risks with Maureen O’Hara, PhD, of Cornell College, shared his perspective.

“First off, ETFs are nice issues,” Bhattacharya stated. “Asset pricing theories would say that buyers ought to maintain absolutely diversified portfolios. That’s in concept. However in observe, retail buyers, different buyers, can’t try this as a result of many of the market just isn’t accessible, property are too pricey, and so forth. So ETFs have helped to resolve a few of these issues.”

However he did spotlight some ETF-related issues. Whereas a lot of these he described as typical of all passive investments, others weren’t. He spoke significantly about ETFs’ heightening impact on market actions, a phenomenon documented by tutorial analysis.

“There’s a set of points which can be distinctive to the ETF due to the construction of the ETF that has to do with the amplification of market actions,” he stated. “Particularly throughout instances of market stress and uncertainty.”

Whereas most panelists acknowledged that ETFs had been hardly threat free, they questioned Bhattacharya’s suggestion that ETFs had an particularly distinct threat profile or an amplification impact. Actually, they agreed that liquidity threat was a priority each for themselves and their shoppers.

“We’ve numerous discussions with shoppers round liquidity,” stated State Avenue’s Bill Ahmuty, head of SPDR mounted earnings. “How are you aware if an ETF is liquid, and what’s driving that liquidity from the first and secondary markets?”

“It’s actually the liquidity of the underlying publicity,” stated Stephanie M. Pierce, the CEO of BNY Mellon Funding Administration’s ETF and index enterprise. “Nevertheless it’s not unprecedented to see a liquid funding car with illiquidity beneath it.”

“Liquidity is clearly the prime concern for us,” Hoffman concurred. “We’re all the time wanting on the liquidity of the underlying, doing our greatest to know how a lot of a liquidity mismatch are you taking over, and that’s going to let you know what your bid–ask unfold and what the unfold between the web asset worth and the worth of the ETF are going to be available in the market in periods of stress.”

Since liquidity threat is a matter for every kind of securities, particularly those who have an illiquid asset beneath a liquid one, members didn’t see that as ETF-specific. In truth, they discovered such issues had been a lot much less pronounced for ETFs than for different merchandise.

“With a lot consideration on the chance of the ETF construction, it’s shocking to me that many buyers and advisers overlook most associated dangers with mutual funds,” stated John Penney, CFA, a senior advisor marketing consultant for Invesco’s registered funding advisor (RIA) division. “ETFs can, actually, alleviate some friction that mutual funds might expertise in periods of volatility and heavy promoting.”

Certainly, some panelists steered the visibility that ETFs present implies that they’re underneath extra of a microscope. Much less clear securities which will have higher systemic threat potential obtain much less scrutiny merely as a consequence of their opaqueness.

“There’s 29 years of empirical proof globally about how ETFs behave via all market occasions. That empirical proof is sufficient to shut down the continuing conversations round ETFs being catalysts for some system-wide occasion,” Browne stated. “When you have ETFs, you’ve SMAs, you’ve mutual funds, you’ve CITs. You could have so many various buildings that use underlying property. ETFs, as a result of they’re clear, everybody’s pointing to the ETF construction as being the catalyst. However but, it’s a car for true transparency in actual time.”

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“Know What You Personal”

No matter their perspective on the potential systemic threat implications of ETFs, all of the panelists underlined the significance of training.

And far of that got here right down to a easy idea: What Pierce known as, “Know what you personal.”

“‘Know what you personal’ is an idea we educate many consumers on,” Ahmuty added. “We focus numerous assets towards educating individuals on ETF mechanics, the significance of liquidity, and the way it all impacts complete price of ETF possession. What we discover is that truly a lot of individuals need assistance understanding what they personal, even subtle buyers.”

ETFs are a comparatively new innovation and so they proceed to evolve. As their use circumstances develop, as with all safety, so too will their potential dangers. So the extra data — amongst professionals and the general public — the higher.

“I think about myself nearly a 20-year ETF novice,” stated Steve Oh, head of ETF Listings at NASDAQ. “I exploit that phrase as a result of our trade is rising quickly. Even the consultants on this room must sustain with what’s occurring.”

For extra on exchange-traded funds (ETFs), don’t miss A Comprehensive Guide to Exchange-Traded Funds (ETFs) by Joanne M. Hill, Dave Nadig, and Matt Hougan from the CFA Institute Research Foundation.

For those who appreciated this publish, don’t overlook to subscribe to the Enterprising Investor.

All posts are the opinion of the writer. As such, they shouldn’t be construed as funding recommendation, nor do the opinions expressed essentially mirror the views of CFA Institute or the writer’s employer.

Picture credit score: ©Getty Photographs/combomambo

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Paul McCaffrey

Paul McCaffrey is the editor of Enterprising Investor at CFA Institute. Beforehand, he served as an editor on the H.W. Wilson Firm. His writing has appeared in Monetary Planning and DailyFinance, amongst different publications. He holds a BA in English from Vassar School and an MA in journalism from the Metropolis College of New York (CUNY) Graduate Faculty of Journalism.

Paul Kovarsky, CFA

Paul Kovarsky, CFA, is a director, Institutional Partnerships, at CFA Institute.

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