The so-called momentum risk posed by the tremendous growth in popularity of exchange-traded funds is just scaremongering created by an increasingly desperate active management industry.
That's the view of Stewart Aldcroft, managing director at Citi Markets & Securities Services, and others in the market, who believe the dangers are being exaggerated and that ETFs can actually help make markets more efficient during periods of stress.
“There's been quite a lot written recently about the rapid growth in ETFs and the possibility of this leading to market risks, some unforeseen, especially in the event of possible rapid outflows," Aldcroft told AsianInvestor.
“Most of this is nonsense, and often being stimulated by active fund managers, who are having some real difficulties in raising new money.”
Leon Mirochnik, head of business development at ETF promoter Enhanced Investment Products agreed, pointing out that although the ETF market is growing fast, it does not yet have the scale to affect markets to the extent being suggested.
“You’d need the ETF ecosystem to get larger and even more directional than it is now to have the significant contagion risk that you might hear some people on the active side talking about.”
At its quarterly portfolio briefing last week, the Australian Future Fund’s chief executive David Neal touched on the topic of the risk building in markets, and the potential danger of too much momentum.
“There is a theoretical point at which too much index fund money is not good for the market. But I don’t think we are remotely close to that,” Neal said.
However, he did qualify that comment by saying “ETF activity may be creating some risks,” and suggesting problems could occur “when a lot of people try to squeeze out of ETFs.”
Jessica Cutrera, managing director of Hong Kong-based wealth advisor Capital Company told AsianInvestor that she doesn’t think such worries are valid. “Most physical ETFs are large and very liquid, with substantial support by the issuer.”
She agreed there are potentially valid concerns around less liquid products wrapped in an ETF –certain types of debt for example.
Still small
Net inflows into exchange-traded products listed globally totaled $391.3 billion in the first seven months of this year, already outstripping the $390.4 billion recorded for the whole of 2016, according to consultancy ETFGI.
But as Susan Chan, head of iShares and index investing in Asia Pacific for BlackRock, pointed out, despite this growing popularity, indexing is still small compared with the value of overall capital markets.
“Indexed assets represent just 10% of the more than $160 trillion of the total market value of global fixed income and equity assets,” she told AsianInvestor. “Further, active trading clearly dominates the buying and selling of stocks and bonds. For every $1 traded by a passive or index manager, roughly $22 are traded by active managers who seek to profit from mispricing.”
The potential for ETFs to distort markets or encourage contagion is not much different from that of some of the mega-mutual funds, if they were to also need unwinding, according to Citi's Aldcroft.
“The proportion of global securities market cap that ETFs represent is at most 2%, although in some markets the proportion of average daily turnover is up to 40% to 50%," he said. "This is a reflection of the lack of volatility in markets over the last nine months or so, and also a lack of viable alternatives.”
In the event of there being a sudden outflow from ETFs, there will need to buyers on the other side of such trades, he said, who for a suitable price would be willing to buy those securities being sold.
“This does and will inevitably impact the trading price of the ETF on the market, but that's the whole point. They can still be traded, unlike many mutual funds which throw up 'gates' as soon as there is a run on their assets.”
Shooting the messenger
Blaming ETFs for market volatility is like shooting the messenger, said Susan Chan. Rather than being a circuit breaker, she suggested ETFs help underlying markets find a price when trading stalls: “ETF trading surges in times of stress because trading naturally gravitates to the most liquid instrument. The ETF serves as a vehicle for price discovery and a safety valve.”
That theory has been thoroughly tested, she said, in periods of market stress such as the Bernanke ‘taper tantrum’ in May 2013 and the closure of the Third Avenue Focused Credit fund in December 2015, amid a liquidity crunch and a decline in the high yield market.
At the time, an iShares’ high-yield bond ETF traded $4.3 billion in the secondary market, said Chan. “It was the most ever for a corporate bond ETF, serving as a significant source of incremental liquidity and price discovery in highly volatile markets.”
During the Taper Tantrum, the same ETF's average daily volume doubled from the month before to $538 million, she added.
An escalation of the rivalry between passive and active proponents is to be expected, according to Frederick Chu, head of ETFs at China Asset Management in Hong Kong. "I suppose an ongoing wrestling between active and passive is unavoidable. However, active and passive, in my view, should not be mutually exclusive, as one seeks alpha and the other aims for beta," said Chu.
In reality, he said the herding concern is less about ETFs and more about investor behaviour and market timing, where is his view "the same applies to mutual funds and single stocks".
For investors concerned about the ETF momentum driving markets to unsustainable levels, Mirochnik advises people to look at the underlying liquidity of the market. “How big is it, and how big is the ETF relative to that underlying liquidity.”
He said ETF liquidity in niche products could be tested in a serious market downturn, “but by themselves, I don’t think they are a risk to markets.”
