Some investors are increasingly worried about the risks posted by exchange-traded funds as the industry grows ever larger, with assets under management globally rising another 20.6% in 2017 to $4.3 trillion as of end-July, according to ETFGI.

Bryan Goh, chief investment officer for Singapore at Swiss private bank Bordier, has added his voice to those warning that these products pose a danger to financial markets.

“Most investors believe systemic risk stems from leverage," he told AsianInvestor, "but the biggest systemic risk actually comes from ETFs." What's more, use of risk management systems may even exacerbate the problem, he suggested. 

“Our strategy is to avoid the overvalued areas of the market," said Goh, "and the overvalued areas tend to be correlated with areas where you find a lot of exchange-traded funds [ETFs] and mutual funds investing into them."

Passive investment strategies generally invest according to index weightings (which are usually based on market capitalisation of bonds or stocks) and active mutual funds tend to benchmark their performance against indexes.

Hence ETFs and mutual funds pool the capital of many investors based on the decisions of a small number of portfolio managers or on automated systems buying and selling according to benchmark weights, he noted.

However, said Goh, for systemic stability there should be many more counterparties making independent trading decisions rather than a small number controlling large amounts of capital.

Bryan Goh: developed-market equities are overvalued thanks to ETFs

His comments come against a backdrop of consecutive years of rapid growth for the passive investment industry. Net inflows into exchange-traded products (ETPs) listed globally totalled $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.

Equity ETPs drew the largest net inflows ($272.21 billion) over that period, followed by fixed income products ($96.1 billion) and commodities ($4.2 billion), noted London-based ETFGI.

“Overvalued” sectors

ETF industry growth is posing risks in certain areas of the markets in particular, according industry observers. 

Goh said US and other developed-market stocks and global/US high yield were notable examples of overvalued market sectors. Others have also voiced concerns that the tide of money pouring into passive investments was contributing to a bubble in US stocks.

Fixed income assets are not immune, either. French smart-beta fund house Tobam has warned that index funds based on traditional market cap benchmarks meant credit ETFs faced concentration risk problems that many investors were unaware of, as reported last week.

Morevover, in markets driven by retail or ETF participation, using risk management systems is unlikely to help because of “herd mentality” behaviour, noted Goh. “If everyone uses the same risk management system, for instance, they can potentially trigger a sell call on the same day and [based] on the same criteria."

Overblown fears?

However, Deborah Fuhr, managing partner at ETFGI, said fears about ETFs taking over the investment world were overblown. There is a lingering misperception of how these products work and the relative size of their universe, she argued.

“ETFs/ETPs still account for a very small proportion of total mutual fund assets [9.4% as of the end of March],” Fuhr added.

What's more, she noted, ETFs are not only used by short-term-focused retail investors. “More than half of [buyers] hold these products for the long term [more than two years]. Contrary to popular perception, it is not just used by investors who change their views frequently.”

And there are understandable reasons for the growth of ETFs. A combination of ever lower passive investment fees and the relatively poor performance of many actively managed funds has driven the surge in ETF demand.

A report published in May by the Investment Company Institute found that the average expense ratio (on an asset-weighted basis) for long-term equity mutual funds fell to 0.63% in 2016 from 1.04% in 1996. For bond funds, it dropped to 0.51% from 0.84%, according to the document, Trends in the Expenses and Fees of Funds, 2016.

Meanwhile, equity index funds saw the AER fall to 0.23% in 2016 from 0.34% in 2009, while for bond index funds it slipped to 0.20% last year from a peak of 0.26% in 2013, the report noted. The expense ratio is the annual fee charged by ETFs or mutual funds.

To provide the latest insights on Asia's ETF scene, AsianInvestor is co-hosting Inside ETFs Asia, the leading global ETF event, at the Grand Hyatt in Hong Kong on November 8-9. For further details, visit the website or contact Terry Rayner via email or on +852 31751963