Investment: Exchange traded funds

Regulators fret that their rapid rise poses risks to the system

There are well over 2,500 of them and they offer the chance to profit from movements in anything from top stock market indices to the world’s waste management industry. Called exchange traded funds, they have emerged from nowhere in recent years to become hugely popular among big institutions and private investors alike.

So rapid has been their proliferation, so easy their use and so wide-ranging their functions that some compare these funds with a nowadays familiar type of application in the realm of information technology. The “product suite” of ETFs is expanding “at a similar pace and scope to smartphone app development”, says Nicholas Colas, chief market strategist at CovergEx Group, a New York technology investment company.

Unlike other funds, they can be bought and sold at any time, just as individual stocks are, and for lower fees. As a result, the ETF industry has expanded by 40 per cent a year for the past decade and now has nearly $1,500bn of assets under management.

To their defenders, they are a refreshingly cheap and simple way of investing whose success is threatening the traditional asset management industry. But to their detractors, they could be the next systemic risk – with striking parallels to the credit derivatives that sparked the financial crisis.

Global regulators in recent months have been falling over themselves to warn of the potential risks that ETFs pose to financial stability. “The lesson of the crisis is that authorities need to pay attention when we see complexity and liquidity and maturity transformation. In the case of some complex ETFs we have seen these things, and it is important that investors know what they are getting,” says Jaime Caruana, head of the Bank of International Settlements, the central banks’ central bank.

For regulators chastened by largely missing the dangers associated with credit derivatives before the 2008 collapse of Bear Stearns and Lehman Brothers, the worries about ETFs represent their first big test in the post-crisis world. They have responded by explicitly drawing the comparison with credit derivatives while fretting about the complexity and opacity of ETFs and how banks are using them.

The rapid growth of ETFs is potentially changing the trading of assets from equities to commodities in subtle ways, leading to concerns they could pose big problems in times of market volatility. So are they really the next systemic risk or are regulators in danger of being oversensitive?

ETFs started off tracking only a few of the biggest share indices worldwide. But the estimated 2,670 ETFs in existence by the end of April relate to just about every asset in sectors and markets with varying degrees of specialisation and complexity. Investors can buy ETFs that, for instance, bet against – or “short”, in the parlance – the S&P 500 or ones that use leverage to offer two or three times the performance of an index. ETFs work by buying all or some of the underlying assets they track or by entering into a derivative contract with a bank to give investors the same return.

Crucially, the breadth of their popularity could place individual investors at the centre of a future crisis – unlike the credit boom and bust of the last decade, which largely played out between banks and so-called sophisticated investors. It also raises questions about how aware all who hold them are about the structure and risks of ETFs. “Are they being sold, at least in the retail industry, with the proper health warnings?” asks Robert Parker of the International Capital Market Association, an industry grouping.

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A warning bell over the role of ETFs was sounded in Wall Street’s equity “flash crash” of May 2010, when share prices of many companies plummeted in a matter of minutes for little obvious reason. ETFs accounted for 70 per cent of the cancelled trades that ensued – despite representing only 11 per cent of securities in the US.

Regulators and investors fret that the rapid growth of ETFs has not only changed markets in unknown ways but could exert an outsized influence on the underlying assets at times of acute market stress. “What no one knows for sure is how ETF investors and traders will respond during periods of extended volatility,” says Mr Colas. “Why? Well, because the latest growth spurt of ETF assets has come in the last two years, and market volatility has been little more than a bug in front of the speeding 18-wheeler of capital markets liquidity.”

Hedge funds and other sophisticated investors such as bank trading desks have caught on to the possibility of making money through arbitrage, which exploits mispricing between the ETFs and their underlying assets. One prospectus seen by the Financial Times, for a Dublin-registered group called Salix Capital, shows the attraction of trading ETFs. It notes how LQD, a corporate bond ETF, “consistently and materially” trades at different levels to its underlying assets.

Regulators are uncertain of the consequences of such trading. The Financial Stability Board, which co-ordinates global regulators, says “further study” is needed to see how heavy ETF trading affects the pricing and liquidity of the underlying assets. This is a particular concern now that ETFs are moving away from assets that are frequently traded to areas such as emerging markets or corporate bonds where activity is more muted. Dan Fuss, a bond market veteran and vice-chairman of Loomis Sayles, a Boston-based investment manager, says: “I worry about the liquidity function of markets in the event that you get substantial withdrawals from the ETFs. High-yield and emerging market bonds are markets where the liquidity can roar in and then roar out.”

A related worry is that the rise of ETFs has coincided with an increase in correlation between asset classes. That means different markets such as equities, commodities, currencies and bonds increasingly move in lock-step – what is called “risk-on, risk-off” trading. The BIS report worries that heavy withdrawals from ETFs could cause correlation to intensify even more, magnifying any sell-off.

Concerns also abound over the practice of shorting, or betting against an ETF. Investors do this by borrowing ETF stock then selling it in the hope of buying it back more cheaply. But a quirk of ETFs is that short-sellers can borrow far more than 100 per cent of the shares, leading to worries about a flurry of unsettled trades. “I don’t think anybody understands how this would rebound into the financial system if things went wrong,” says Terry Smith, a City of London veteran and founder of an actively managed equity fund.

Generally, ETFs can be divided into two types. The original and simplest are known as physical or plain-vanilla ETFs and seek to replicate the index they track by buying all or most of the securities in that index. But increasingly popular in Europe are synthetic ETFs, which represent nearly half of the market, where the fund providers buy a derivative known as a swap, often from their parent bank. The swap gives them the return from the index without having to own the underlying shares. In return, the bank gives the fund provider shares and sometimes bonds as collateral, although they are often of a completely different nature to the assets in the index a fund is tracking.

A striking example is provided by Deutsche Bank’s “db x-trackers Euro Stoxx 50” ETF, which tracks the index of Europe’s 50 biggest companies. The two biggest components of its collateral are equities not from Europe but the US, comprising 44 per cent, and Japan, making up 20 per cent. “The mismatch between what you think you are getting and what you get can be big,” says Mr Smith.

The rise of synthetic ETFs in Europe and Asia has led to many of the worries from regulators globally. The US Securities and Exchange Commission was first to act in March 2010, suspending the launch of any new synthetic ETFs while it reviewed the use of derivatives.

ETFs “are not just bread-and-butter products any more but they include complex structured products too”, says Steven Maijoor, the chairman of the European Securities and Markets Authority, which will issue its own policy document on ETFs next month. “It is no surprise that that has the attention of supervisors.”

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Global regulators are now fretting about early signs that banks are using ETFs to help fund their holdings of poor-quality shares and bonds more cheaply than they normally would in the so-called repo (repurchase) markets. “The synthetic ETF creation process may be driven by the possibility for the bank to raise funding against an illiquid portfolio that cannot otherwise be financed in the repo market,” the FSB said in April in its first ever report on potential vulnerabilities in markets.

The BIS in turn worries that another crisis could bring a run on such ETFs, as investors would worry about counterparty risk – their exposure to banks and other financial institutions. Big withdrawals could lead to the banks having difficulty in selling the collateral or threaten the banks’ own funding models.

ETF providers have responded by arguing that they disclose more information about their funds’ holdings than other parts of the asset management industry. “The ETF industry is light-years ahead of the rest of the industry in terms of transparency,” says Ted Hood, chief executive of Source, an ETF backed by several large investment banks. But he adds that the industry needs to educate investors more on the specifics of ETFs, such as collateral: “It means it is a product where you might not understand how it does what it does, but it will deliver what it says.”

Valerie Baudson, head of Amundi ETF in France, argues that a comparison with credit derivatives such as credit default swaps is unhelpful because all European ETFs are covered by the so-called Ucits III regulation. “An ETF isn’t the same type of product as a CDS. It remains a fund that is well known and well regulated.” Talking about the regulatory scrutiny, she adds: “Anything that can help transparency is good for us.”

What regulators might propose is still to be decided. Investors say that similar warnings about various types of product will become increasingly common as regulators react to the stinging criticism of their performance leading up to the financial crisis. “As a regulator, you are now somewhat oversensitive not just about the strength of the financial system but where future problems might be,” says Icma’s Mr Parker.

It is an issue of which regulators are highly conscious. At the BIS, Mr Caruana says: “Some people will say, ‘you are exaggerating’ and probably you have the problem of crying wolf. But authorities need to do that.”

He is clear that the attention watchdogs are devoting to ETFs is more because of the potential for trouble in a corner of an otherwise healthy market rather than something more sinister. “The issue is that authorities need to monitor new things like ETFs at the first stage, when they are not very risky and when they have not yet become a very big part of the system,” he says. “What we intend is that people should think about this issue of complexity: investors should, the providers should.”

Additional reporting by Izabella Kaminska

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