Leaky structures: battle lines are drawn

Exchange traded funds are driving a revolution in financial markets and the pace of change is accelerating.

But as ETFs become increasingly popular, more questions are being asked about their risks.

Critics cite a number of recent difficulties in trading ETFs as evidence that problems in the industry’s “plumbing” systems flare up in periods of market stress. They complain that the rapid growth of the ETF industry is concentrating risks and could threaten large scale market disruption.

ETF managers vehemently dispute these claims. They say that the critics misunderstand how ETFs perform and the benefits they offer investors.

Mark Wiedman, global head of iShares, the ETF arm of BlackRock, the world’s largest fund manager, says ETFs acquitted themselves “with flying colours” in the latest bout of market turmoil in late May and June.

ETF activity tends to rise significantly when market volatility increases. Mr Wiedman says that fact has provided investors with greater confidence that ETFs are robust in periods of stress.

He predicts that “ETFs will play a much bigger role in global capital markets as both institutional and retail investors become more comfortable with advantages offered by this new technology”.

Global inflows into ETFs (funds and products) reached $148.5bn in the first seven months of the year, up 13.8 per cent compared with the same period in 2012, according to ETFGI, a consultancy.

The strength of the overall inflows is notable as it has coincided with severe weakness in two previously vital drivers of the industry’s growth, gold and emerging markets ETFs, where investors have withdrawn more than $40bn so far this year.

The US ETF market remains the primary generator of growth, responsible for almost 80 per cent of global inflows this year, helped by the S&P 500’s rally to an all-time high.

Scott Ebner, global head of product development and research at State Street Global Advisors, says some observers describe the US ETF market as mature but it is still in a growth phase.

Mr Wiedman echoes this, saying ETFs are becoming the preferred vehicle of choice for passive exposures for both US financial advisers and retail investors, outside 401k retirement plans.

“But there is much more growth ahead. With $750bn invested by US retail investors in ETFs compared with their holdings of $10.2tn in US active mutual funds, ETFs still have a lot of catching-up to do,” he says.

In the US, ETFs regularly trade more than $60bn on a daily basis, regularly accounting for a quarter of all US stock market activity by value.

“ETFs are attractive to both long-term holders due to their low fees as well as active traders because of their tight spreads,” says Phil Mackintosh, global head of trading strategy at Credit Suisse.

Critics argue that ETFs linked to less liquid underlying assets, such as high yield bonds, have not lived up to their expected standards when volatility rises.

But industry participants reject this charge.

“The costs of trading some ETFs may be higher in times of market stress. But ETF trading takes place in a highly competitive environment and the additional utility that ETFs offer via intraday trading is extremely valuable,” says Mr Ebner.

Mr Wiedman adds that growing trading volumes in fixed income ETFs demonstrate that more investors want to transact in a public marketplace where prices are transparent rather than via opaque over-the-counter transactions.

The industry’s rapid growth is leading to mounting competitive pressures, particularly in the US.

Providers loathe the suggestion that they are fighting a “price war” to secure market share, aware that their profit margins could suffer if they cut charges aggressively without a corresponding increase in asset growth.

Most product launches, however, are competitively priced against established rivals, as demonstrated recently by Charles Schwab’s new smart beta range which undercut established rivals.

In Europe, significant changes are also afoot.

BlackRock, already the largest player in Europe, acquired Credit Suisse’s ETF operations earlier this year as part of a move to boost its presence in Switzerland. Warburg Pincus, the private equity group, has said it would like to acquire ETF businesses in Europe while Amundi, the French asset manager, has signalled its appetite to act in any consolidation wave.

Vanguard has rapidly accumulated more than $1bn in assets just a year after launching its first European listed ETFs while SSgA’s European operations have picked up pace and new entrants such as First Trust are continuing to target the region.

Deutsche Bank and Lyxor have revamped their business models to respond to these new competitive pressures.

“We expect to see more managers from around the world wanting to enter the European ETF market to offer investors access to a wider range of expertise from within the asset management community,” says Matt Johnson, European head of distribution at ETF Securities, the London based provider.

Asian ETF markets, while at a much earlier stage of development, are also developing rapidly, most clearly in China where the process of liberalising capital markets has led to a spate of new products being launched.

But other Asian countries are also innovating, such as the Philippines which has just started accepting listing applications for ETFs.

As the industry develops, it remains unclear just how many of the large existing array of sub-scale ETFs have a sustainable long-term future. A record number of products closed in the first half of the year, suggesting a growing realism among providers that not every launch will prosper.

Mr Mackintosh at Credit Suisse notes that the majority of assets are in ETFs that have an expense ratio less than 30 basis points while trading is heavily concentrated in products with a bid-ask spread less than 3bp, underlining the cut-throat level of competition.

With 4,883 exchange traded funds and products currently available, it might appear that the limits of innovation are being tested, as shown by the sceptical reaction that followed recent proposals for a Bitcoin ETF.

However, as the strong demand this year for currency hedged Japanese equity ETFs has demonstrated, even relatively simple product innovations can generate significant inflows if they meet investors’ needs.

Mr Wiedman at iShares points out that fixed income markets remain relatively untapped by ETFs.

“Assets held in fixed income ETFs at just over $300bn make up just a small part of the $100tn invested in bond markets globally. But we expect to see much greater adoption as fixed income ETFs develop greater liquidity and bond-like analytics become more readily available,” he says.

Another potentially rich seam for exploitation lies in advanced or smart beta strategies that offer a different balance of risks and returns than that attached to conventional market capitalisation products.

Advanced beta strategies have been long used by sophisticated institutional investors but these mandates were frequently undisclosed. Although the smart beta term is sometimes misused, ETF flows have given such strategies much greater visibility.

Another unexplored area lies with active ETFs. US regulators recently lifted a ban on the use of derivatives in new ETFs, a move which is expected to pave the way for new products

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