ETF risks highlighted amid sharp market falls in 2022

With equity markets in Asia bearing the brunt of recent bearishness, a new report highlights the risk of contagion from illiquid assets held in some ETFs.
ETF risks highlighted amid sharp market falls in 2022

Investors in local Asian stock markets, particularly in Greater China, have been stung by some fairly hefty negative returns this year - for those using exchange traded funds (ETFs) it has been a lesson in how tracking an index can work against you.

An investment in a popular Hang Seng Index ETF, for example, would be down approximately 40% over the past 12 months and falls of regional indices have been precipitous. Last week, following the close of the National Congress of the Chinese Communist Party, the HSI was down at levels not seen in 13 years.  

Meanwhile, the Shanghai Composite ETF is down over 15% over the same period, while Taiwan’s Taiex index is down almost 25%.

Last Monday, after the CCP Congress, investors pulled a record $2.5 billion out of China’s stock market, according to an analysis by the Financial Times.

Lorraine Tan, director for Asia equities at Morningstar, points to the political reshuffle in China’s ruling party.

“The negative reaction is because of the disappointment over the new seven-man China Communist Party Standing Committee. It implies a more hard-lined approach to the country’s Covid policy and security – possibly at the expense of economic growth.”


ETFs provide a low-cost way of gaining exposure to a market or a targeted basket of assets. They provide a useful function in allowing retail investors and institutions to use them as ballast for a balanced portfolio.

In Japan, for example, the Bank of Japan holds ETFs worth approximately $284 billion, or 64% of the assets invested in the entire ETF industry in Japan, according to research firm ETFGI.  

Despite a consensus view among industry practitioners that ETFs are relatively low risk, as well as being cheap to buy, financial regulators are being pushed to re-examine the risks posed by certain exchange traded funds during periods of market stress.

A report by the IMF, published this month, said policymakers “should further analyse exchange traded funds”.

It stated that funds offering daily redemptions while holding illiquid assets “can amplify the effects of adverse shocks by raising the likelihood of investor runs and asset fire sales. This contributes to volatility in asset markets and potentially threatens financial stability.

“The provision of intraday liquidity by ETFs makes them attractive for liquidity traders with short-term horizons. Together with the arbitrage activities of authorised participants who create and redeem ETF shares, this facilitates the transmission of non-fundamental shocks from short-term liquidity traders to securities markets,” the IMF report said.


The IMF notes that benchmark-driven portfolio flows have increased significantly in recent years, especially for exposure to emerging markets. They argue this poses additional risk as investment flows tend to be highly sensitive to global factors, potentially increasing the risk of excessive outflows at times of market stress.

“These concerns are particularly pertinent now as central banks normalise policy amid heightened uncertainty about the global outlook. A disorderly tightening of financial conditions could trigger significant redemptions from these funds and contribute to stress in asset markets.

Their proposed solution to this is for recipient economies to deepen their domestic markets and use macroeconomic, prudential and capital flow management measures, including foreign exchange intervention.

ETF industry practitioners in Asia contacted by AsianInvestor recognise there is an issue with certain types of ETF.

Tobias Bland, chief executive of Hong Kong-based Enhanced Investment Products said the design of some ETFs is “questionable, where you wrap a set of illiquid securities such as bonds or illiquid stocks and emerging market equities and then sell a new ETF, with daily subscription and redemption.”

“The big fixed income funds will be trading to discounts and so (brokers) will buy and redeem the ETF, which means lots of illiquid securities need to be sold, potentially causing stress in the system,” Bland told AsianInvestor.


He added that Singapore REIT ETFs and other Asian ETFs holding illiquid underlying assets are also posing perhaps unseen risks for investors.

“The key is that redemption means stock must be sold that day.”

Similar concerns have been raised about high yield and investment grade fixed income ETFs, said Deborah Fuhr, managing director of ETFGI.  

But she said the real market evidence is that “the ETFs behaved as they should. During the market meltdown that accompanied the beginning of the Covid pandemic in March 2020, they worked very well.

“Fixed income ETFs have been tested in numerous stressed market scenarios and have proved they offer price discovery and the ability to access liquidity during volatile markets,” she told AsianInvestor.

According to veteran Hong Kong fund industry expert, Stewart Aldcroft, the IMF report follows a similar line to many “trying to pick holes in the ETF business.”

But in his view, “there has been little or no real life experience of ETFs causing market instability. Liquidity issues have never been a problem and pricing has generally been reliable”.

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