Will there be any major blowups in the ETF industry?

The exchange-traded fund industry has doubled in size to exceed $3.5 trillion in the past four years, raising fears about potential problems. Are they justified?
Will there be any major blowups in the ETF industry?

The exchange-traded fund market continues to swell as increasing numbers of investors pour in, but the bigger it gets, the more likely it is that it will suffer problems, or cause problems for the wider industry—so runs one side of the argument.

As part of our series of forecasts for the Year of the Rooster, AsianInvestor put the question to a industry experts: both active and passive managers, and 'neutrals' in the form of asset owners and consultants. Here is our prediction (the full list of which appears in the February/March issue of AsianInvestor magazine).

Will there be any major blowups in the ETF industry?
Answer: No

Back in 2012 industry experts worried the exchange-traded fund (ETF) sector could suffer product failures that would badly damage its reputation. The main issues cited were the counterparty risk of synthetic ETFs and the potentially insufficient liquidity of underlying assets to cope with large fund redemptions.

Such worries have to date been unfounded, despite global ETF assets soaring from $1.88 trillion to $3.546 trillion in the four years to the end of 2016. Indeed, many more specialised and complex products are now available, such as those offering leveraged and inverse exposure, cheap replication of active strategies or access to niche markets.

Market fears have been assuaged by level of desire for the ETF industry to run smoothly. After all, three of the world's largest asset managers—BlackRock, State Street Global Advisors and Vanguard—are the foremost providers of these products. And ETF market-makers include some of the world’s biggest banks. These players should handle even massive redemptions from ETFs that track the most liquid markets, such as the US’s S&P 500 stock index.

Of course, problems can crop up in niche products, particularly in the less liquid parts of fixed income. Yet there is less money invested in such instruments, so it’s easier to create and redeem enough units—or accept small, short-term losses to defend a product.

The potential for liquidity mismatches—which could result in ETFs trading at discounts to net asset value—is a growing concern, but it can be dealt with for now.

Another concern is the extent to which the passive products push up volatility in underlying markets, due to investor herding.

While we don’t expect blowups in ETFs just yet, we are in uncharted territory. All the more reason to monitor developments carefully.

Other Year of the Rooster predictions:

Which investments will perform best this year?

Will more countries vote to leave the European Union?

Will the Bank of Japan be forced to rethink its 10-year bond yield target?

How many rate hikes will the US make this year?

Will Donald Trump spark a trade war with China?

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