ETF’s - Too Big To Fail?
Questioning the liquidity of exchange traded funds (ETFs) is something that has grown in recent years, thanks mostly to the greater number of institutional funds that now use them – bond ETFs particularly – as an alternative to holding cash.
On the face of it, this seems like a good ploy, especially in the current low interest rate environment. Investors understandably don’t like to be told they are being charged for their money not making anything in real terms, even if it is a small part of their overall portfolio that is being held in cash.
However, as the number of institutions using ETFs as cash alternatives has grown, along with the general popularity among retail investors, the ability to liquidate these positions in a stressed market has been called into question.
Institutions investing in ETFs rose to 24.8% in 2018, up from 18.5% in 2017 according to the Greenwich Associates 2018 US Exchange-Traded Funds Study. That is significant, and ETFs have become so prevalent that there are fears they are almost becoming a victim of their own success (too big to fail?). As at April 2019, the assets under management (AUM) for ETFs had risen from US$5 trillion to US$5.6 trillion within a year according to JP Morgan, with more than 8,400 ETFs now available.
The popularity of ETFs has risen due to their low cost structure and for the access to asset classes which were not previously easily accessible. This low fee structures and market access has created an environment where passive ETFs are regularly performing as well as actively managed funds - for investors, it is a win win, whether they are retail or institutional.
The problem experts fear may be on the horizon is how these ETFs can possibly handle a major crisis. Stock markets are around 80% invested through automated entities if quant funds are included alongside ETFs, according to JP Morgan. With little to no human intervention, ETFs will simply buy and sell stocks to maintain the proportional representation of the make-up of the index being tracked, so they will rise and fall at the same rate as the market is rising and falling.
In stable market conditions, liquidity is rarely much of an issue. But in a market crisis, when liquidity evaporates, retail and institutional investors alike could face a myriad of issues especially in the already less liquid portion of the tracked indices (remember the flash crash?).
Leveraged ETFs – where the fund will use derivatives and debt instruments to amplify gains – again work well in neutral or rising market. After all, who doesn’t want to double or triple their gains? But when markets turn, and they do so very quickly, these ETFs also amplify the losses leaving investors in a worse position than they might otherwise have expected. Liquidity in this situation could again become a problem, preventing spooked investors from accessing their cash in the case of a stampede for the exit.
It is little curious then that institutional managers are set to double their investments in liquid alternative ETFs in the next 12 months, according to a survey commissioned by IndexIQ. This suggests these institutions are un-aware of the potential problems being stored up by the greater exposure to both traditional and leveraged ETFs and the liquidity issues they present in a crisis. The key question is whether they manage to redress this balance with ETFs that have a higher liquidity in-built before a crisis hits.
