Market volatility puts pressure on illiquid asset ETFs

The pronounced market volatility and drops experienced in 2018 have revealed a telling issue with exchange traded funds: not all of them are created equal, and some are riskier than others.

Smaller ETFs in particular offer investors a potential danger, because many are not very liquid in the best of times. About 70% of the products have less than $100 million of assets; and 40% of that 70% have under $10 million, said William Kelly, chief executive of the Chartered Alternative Investment Association.

While investors can expect a $250 billion ETF that tracks S&P 500 stocks to maintain its daily trading liquidity, the same is not true for a $10 million product that holds leveraged underlying asset positions.

In periods of market stress the bid/offer spreads of the latter will widen and become subject to order limitations. That means there will still be a price to buy and sell the ETF, but it becomes tied to a specific number of shares that are available at that price.

That can cause problems if many large investors simultaneously seek to offload shares in an ETF that promises to settle within two days but has underlying assets that might take upwards of a week to do so.

In that scenario “the fund will typically trade shares at a price that is below the net asset value of the underlying assets, and the last bid that the investor sees is not likely the price they will get, as limits are quickly filled and the bid price goes down in accordance with the underlying selling volume,” Kelly told AsianInvestor.

Even niche ETFs could also end up being ignored in a financial crash. During times of market panic investors tend to trade what they can, not necessarily what they want. And while exposure-type ETFs simply won’t trade because there’s no liquidity, investors could instead look to trade out of their higher-liquidity ETFs.

“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,” Coverdale said. “The contagion effect is to do with the tradability of the ETFs, rather than any kind of underlying fundamental correlation.”

Adrien Vanderlinden, executive director of the systemic risk office at the Depositary Trading & Clearing Corporation, said investors should be prepared for periods that cause liquidity mismatches between an ETF and its underlying assets, and potentially have a major impact on its valuation.

“This is a potential vulnerability that has been building for years and that may continue to grow, depending on how the ETF landscape evolves,” he told AsianInvestor.

Synthetic ETFs in particular offer a greater possibility of disparities in valuation, particularly during times of market stress.

“Investors’ exposure to market risks [through synthetic ETFs] could – sometimes unknowingly – be amplified,” Rocky Tung, head of capital markets for Asia-Pacific at the CFA Institute, told AsianInvestor.

ETF AS SCAPEGOAT

Yet for all the concerns about ETFs growing too fast, with too little investor understanding for what they are buying, the asset class boasts many supporters.

Deborah Fuhr, managing partner and founder of ETFGI, is one. She argues that the ETF industry remains relatively small, limiting its potential impact on financial markets.

“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,” Fuhr told AsianInvestor.

Rich Powers, head of ETF product management at Vanguard – the world’s second-largest distributor of ETFs and passive products – is similarly dismissive of ETF naysayers: “ETFs accounted for only 13% of global investment assets in 2017, so to attribute market risk to ETFs would be a bit of the tail wagging the dog.”

GFM Management’s Dennison added that even fears around volatility ETFs are overblown, despite the problems that volatility ETFs had in February.

“If you actually look at the documentation, [volatility ETFs] did exactly what it did on the tin. It said if the Vix goes from 14 to 20, the ETF will lose this much,” he said.

While leveraged and inverse ETF products can cause outsized effects, they form a tiny fraction of overall volumes – approximately 1.8% of global ETF AUM. The biggest ETFs remain simple stock index trackers.

Fuhr believes ETFs are getting a bad rap from fund managers that don’t sell the products and thus don’t fully understand them. Dennison agrees: “It’s a fear tactic by those who don’t like the idea of ETFs. I think those claims are way overblown.”

But ETF sceptics argue that it’s a mistake to purely focus on the relatively limited nature of ETFs. The danger is that they haven’t been properly tested, and their interconnectedness could cause greater ructions, said Axioma’s Coverdale.

“ETF’s haven’t experienced a proper bear market where there is sustained and long-term selling pressure. At that point, it is uncertain how ETF’s will behave, and if it’s uncertain then it’s risk,” he said.

ETFs are a cheap and easy way to access a huge variety of market assets. But they are more complicated than they appear, particularly as they become more niche.

Investors would be advised to better familiarise themselves with these risks – particularly given the likelihood of more market turbulence in 2019.

This article was adapted from the cover story of AsianInvestor's December 2018/January 2019 edition.