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The bulk of the $9tn exchange traded funds industry consists of plain vanilla index trackers focused on mainstream assets. But a couple of much higher risk variants are now growing rapidly — albeit from a low base.
Cryptocurrency ETFs may still be awaiting regulatory approval in the US but they have taken off in other jurisdictions including Canada, Switzerland, Germany and Jersey. Total assets in these funds tripled from $3bn at the end of last year to $9bn as of June, according to data from ETFGI, a consultancy.
Meanwhile, the sums committed to leveraged and inverse exchange traded products — which are designed to amplify gains from market rises or conversely profit from falling asset prices — has risen from $79bn at the end of 2019 to a record $109bn, ETFGI has found.
Even the US Securities and Exchange Commission has smoothed the path for some leveraged vehicles — despite maintaining a ban on crypto ETPs. Last October, its commissioners voted by a 3-2 majority to allow ETF providers to offer products with up to 200 per cent leverage without prior approval from the regulator.
Before that decision, a consortium of mainstream fund managers including BlackRock, State Street, Vanguard, Charles Schwab, Fidelity Investments and Invesco — which together control more than 90 per cent of the US ETF market — had started a campaign to have leveraged and inverse products stripped of their ETF designation.
These dominant providers have pointed to the risks inherent in some of the ETF products marketed with SEC approval. One example was a three-times leveraged long crude oil ETP that delisted in April 2020 after a dramatic fall in oil prices wiped out its value. Some investors were also hit hard in 2018 when a spike in the Vix volatility gauge — a measure of predicted swings in US share prices — caused some inverse Vix ETPs to fall in value by more than 90 per cent.
Other observers highlight the dangers faced by less sophisticated retail investors when committing to riskier vehicles. “Perhaps the more poignant cautionary tale is the products that attracted investors seeking income, who are often retirees [during last year’s Covid-induced market crash],” says Bob Jenkins, global head of Lipper Research, Refinitiv.
He points to the example of one two-times leveraged, high-dividend, low volatility ETF that suffered losses of 60 per cent during March 2020. “If you allocated a large part of your nest egg to a fund like this in order to pump up your monthly income stream in a low-rate environment, you could have suffered devastating losses,” he says. “And there are stories out there of retired investors who experienced just that.”
ETFs, adds Jenkins, “are still considered a benign product, but when you are buying a leveraged product on margin you know it’s Las Vegas. You are betting on black”.
In the 1990s, Jenkins ran a trading desk for “extremely rich, very sophisticated, self-directed day traders”. But despite his clients’ sophistication, he still assessed each trader’s knowledge and experience and granted them a given level of access based on that. Only the most advanced traders were able to engage in so-called naked shorting — selling shares that were not yet even in their possession.
His view is that retail brokerages today should have similar checks in place to ensure investors understand the risk of ETPs — and can withstand the potential losses.
Where to draw the line, though, is open to question. Deborah Fuhr, founder of ETFGI, wonders: “Should a regulator regulate what investors can invest in? Is the ecosystem robust enough to give comfort to the regulator? I’m not sure.”
“The [ETP] industry would say if investors read the prospectus, that clearly describes what they are doing and how they are doing it,” she points out. “The challenge is that many investors do not read the prospectus fully and they often make assumptions that may not be accurate.”
With leveraged products, the mathematics of “volatility drag” mean that returns are statistically more likely to worsen the longer they are held, Fuhr explains — although this is not inevitable.
As for crypto or digital assets, she says they are impossible to price rationally. She draws a comparison with the inherent difficulty in valuing “blank cheque” Spacs (special purpose acquisition companies) before they even buy a business.
Despite these risks, trading in cryptocurrencies is aggressively marketed in many territories, notes Peter Sleep, senior portfolio manager at Seven Investment Management. In the UK, for instance, passengers are assailed by adverts for crypto platforms on the London Underground. Against this backdrop, he argues that bitcoin ETPs offered by a “respected counterparty”, such as white-label ETF platform HANetf, can offer more structure and security than trading cryptocurrencies directly.
Frank Spiteri, chief revenue officer of CoinShares, which also offers ETPs based on cryptocurrencies, suggests the underlying assets are “no more volatile than the oil and gas industry.”
More investors appear keen on the risk-to-reward profile of such products. Ed Egilinsky, managing director of Direxion, one of the largest providers of leveraged and inverse ETFs, says his business had seen an upsurge in retail investor interest since the start of the pandemic and now has $26bn under management.
But Egilinsky says all investors, regardless of their sophistication, “have to do their homework”. All new clients are referred to the educational section of Direxion’s website and advised on the kind of investors at whom these ETFs are aimed. “If people are looking for a buy-and-hold investment, these are not the right investment for them,” he adds.
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