Exchange traded funds (ETFs) and other passive investment products have proliferated in the last few years, providing investors with greater trading flexibility and portfolio diversification benefits at a lower cost than traditional mutual funds or actively managed products.

But there are some potential pitfalls if you look closely, warns Kristian Fok, chief investment officer at Construction and Building Unions Superannuation (Cbus).

Total assets held in ETFs and exchange traded products (ETPs) rose to $5.23 trillion in August, marking the 55th consecutive month of net capital inflows globally, according to data from ETF consultancy ETFGI.

However, as ETFs have grown more sophisticated they are also becoming more heterogeneous with inherently different risk profiles.

“I think we’d be careful around some of the ETF instruments – not so much the ones that are backed by listed and liquid underlying securities, but I think the ones where there’s a mismatch, those that invest in less liquid strategies,” Fok told AsianInvestor.

Kristian Fok, Cbus

Many of the ETF products being developed now are quite different from the traditional cap-weighted index replication vehicles, offering investors exposure to alternative index construction schemes like volatility management strategies.

The risk with these exposure-type ETFs is that there may be mismatches in the composition of the ETF and the underlying vehicle, Joel Coverdale, head of Asia-Pacific at risk consultancy Axioma, said.

“In a time of crisis, the movement that you can get between the two will not necessarily be perfectly correlated, and we saw this with the Vix ETF, whereby there’s a layered risk associated with the fact that they’re leveraged and they’re not trading something that fundamentally is an asset that normally is used for trading,” Coverdale told AsianInvestor.

The Cboe Vix index is a measure of expected stock market volatility based on S&P 500 index options. After it spiked to 37.32 on February 6, Credit Suisse’s VelocityShares Daily Inverse VIX Short-Term Exchange Traded Note (ETN) lost 96.3% of its value. The Swiss bank made the decision to stop issuing new units of the ETN on February 20.

CONTAGION POTENTIAL

Such ETFs are a possible area of over-exposure for investors, similar to a decade ago when investors were over-exposed to collateralised debt obligations (CDOs), contributing to the global financial crisis, Cbus’s Fok said.

With this year's increase in market volatility and global trade tensions, and shift towards quantitative tightening, investors should be prepared for periods of stress that could exacerbate any mismatches in liquidity between an ETF and its underlying assets.

This is a point in the market cycle where all investors should understand the path to liquidity in times of stress, said William Kelly, chief executive of the Chartered Alternative Investment Association (CAIA).

"Leveraged or thinly-traded securities might have provided big benefits post the [global financial crisis], but that can brutally and quickly cut both ways – in a GFC 2.0 scenario, it is less than certain that the previous and very accommodating central banker will bail out your ETF," Kelly told AsianInvestor.

Part of the contagion risk is to do with the fact that investors tend to trade what they can – which will most likely be their most liquid investments – and not necessarily what they want, and liquidity becomes a major factor dictating correlated performance across what might otherwise look like uncorrelated assets.

“You begin to see correlations in terms of assets that are driven by liquidity and not by the normal fundamental relationships that we might expect to drive correlation,” Axioma’s Coverdale said.

ETF AS SCAPEGOAT

However, fears of ETFs being a source of contagion are overblown given the relatively small size of the ETF industry, said Deborah Fuhr, managing partner and founder of ETFGI.

“They’ve grown a lot but relative to mutual funds and structured products and other things, they’re still tiny – globally they’re like 12% of all mutual fund assets, so I just don’t see it,” Fuhr told AsianInvestor.

The majority of trading in ETFs is also on a secondary basis, which means that even if investors’ have a negative view on ETFs, it won’t necessarily result in a sell-off.

“The benefit of the secondary trading is people can go short ETFs … some people might borrow out to put on a short trade or a hedge, so they have different ways of being used. Over 50% of investors hold ETFs as core holdings, so not everyone during the downturn sells,” said Fuhr.

ETFs get a bit of a bad rap because many people who don’t have ETFs create various concerns about them because they don’t understand them, she added.

While it is true that ultimately there is a secondary market for the ETF itself, said Axioma’s Coverdale, at some point the ETF market makers still need to deliver the underlying basket of securities.

At that point, the risk is either shifted to the end investor and the pricing will fairly reflect the underlying securities, or in the case of market stress you might see a situation where the market maker or ETF provider decide to price it at what they term to be a fair market price and take the risk that the underlying may not be tradable, he added.