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The next financial crisis will be played out in indexes and exchange traded funds. That is inevitable given the huge share that ETFs now take of investor fund flows, and their popularity as hedge fund trading vehicles.

What is less clear, and deeply controversial, is whether the structure of ETFs will itself contribute to the next crisis, or even cause it. Regulators, worried by past incidents when untested financial innovations helped exacerbate financial crises, are worried that it could.

ETF providers indignantly counter that they make the market more liquid, and less prone to sudden stops. Indeed, they complain that well-intentioned regulations exacerbate a problem they were meant to cure.

The scale of the ETF industry is not in question. They now hold more than $3tn in assets. But this raises the question of whether they have come to lead the market rather than follow it. This operates at two levels. First, there is a concern that the power of the indexes distorts markets over time, and second, there is the possibility that the structure of ETFs and index funds worsens market shocks when they happen.

Indexes’ influence spreads to virtually all institutionally managed funds. Benchmarking by the consultants on whom institutions rely when choosing fund managers is so widespread, that active managers have no choice but to watch the index they are compared to very closely, and are obliged to follow any major changes in its composition.

Examples are easy to come by. When the Russell indices — highly popular among US fund managers — are updated each year, they often drive the heaviest trading of the year. In June this year, Chinese A-shares peaked and began to fall shortly after MSCI, the most important index provider for emerging markets, decided to delay including them in its flagship index. This came as a surprise. Showing the importance of indexers, Chinese authorities had lobbied hard for inclusion, as this would have driven capital into the A-shares market. Many investors at the time said that the subsequent sell-off could in part be attributed to the knock to confidence that came with MSCI’s decision.

Indexers do their best to limit their impact on the market. Russell makes its methodology very public, so investors can see weeks in advance what changes are likely to its indices. MSCI conducts public consultations.

But while indexing and benchmarking remain so prevalent, the problem of overpowerful indexes seems impossible to avoid. It can merely be mitigated. For passive investors, rules for indexes must remain as clear as possible. For active managers, the solution may be to change benchmarking. Rather than looking at past performance, which does not predict the future, consultants could look at investors’ past behaviour, or rate them on their degree of style discipline. If clients show that they are more interested in highly concentrated funds taking contrarian positions, and not in funds that merely shadow an index, then the industry would adjust to meet the demand, and the systemic problems caused by indexes should reduce.

Then there is the issue of market structure. Two incidents in 2015 raised concern. First, there was August 24, when US share prices gapped downwards at the opening in New York, and ETF prices were not available for a while. Second, in December, a gradual sell-off in high-yield bonds turned into a rout for ETFs holding high-yield bonds.

Was this due to liquidity mismatches? It is a fair question. ETFs only offer prices throughout the trading day because market makers trade to ensure that there is no gap between the market price and the underlying price of the securities in the index they track, so this has to be a risk — especially when, as in the case of high-yield bonds, the underlying security is fundamentally less liquid.

There are two theories. One, held by the industry, is that the problems were driven if anything by regulations. Mandatory trading pauses following the 2010 “flash crash” made it harder for ETF managers to get a handle on the underlying price of their securities, and created problems. The other theory: there is indeed a mismatch.

Debate is healthy. The echoes of credit derivatives, which in 2008 helped to turn a serious housing downturn into a near-collapse of the world financial system, are clear enough. Without a major market disruption — and 2015’s turbulence barely ranks compared with the events of 2008 — it is hard to test whether new financial instruments will work as intended when under stress. Better for everyone, including ETF providers, to err on the side of caution.

Copyright The Financial Times Limited 2017. All rights reserved.

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