Year of the Rooster: Were ETFs a ticking timebomb?

The rise of exchange-traded funds led AsianInvestor to ask experts whether there would be any problems among these vehicles. They offered some interesting insights.
Year of the Rooster: Were ETFs a ticking timebomb?

The rise and rise of exchange-traded fund (ETF) assets under management across the world has been a hallmark of the global fund industry over the past decade and more. However, some industry participants (primarily, it must be said, in active fund houses) have claimed that this level of passive investing could exacerbate market swings and potentially cause problems. 

Given the rising importance of this market segment, we decided to ask experts whether there could be any ETF problems by asking the following for our Year of the Rooster predictions: 

Will there be any major blowups in the ETF industry? 

Answer: No

As we noted, worries about ETFs had been rising since at least 2012, over fears that synthetic ETFs might cause counterparty risk and that other types of the vehicles might lack sufficient liquidity in their underlying investments to make up for promises of daily liquidity in the vehicle. 

And yet there have been no signs of these concerns transpiring, despite ETF assets rising from $1.88 trillion in 2012 to $3.42 trillion in 2016. Sure enough, equity markets kept on rising throughout last year, and with them the appeal of ETFs. Their combined AUM surpassed $4 trillion last year as individual investors and retirement funds opted to take advantage of the low costs of these vehicles amid a time of generally rising equity valuations. And in January this year they broke above the $5 trillion mark, according to London-based consultancy ETFGI. 

The world's largest fund managers have been some of the main suppliers of ETFs, principally BlackRock, State Street Global Advisors, and Vanguard, and they are serviced by some of the world's largest counterparties, making a surprise liquidity event a relatively low concern.

While the appeal of various types of ETFs has varied a great deal (some of the instruments listed in Hong Kong have seen their liquidity drop markedly as the gimmicky instruments have fallen out of favour) there have been no structural reasons to be concerned about their performance. 

Of course, concerns about ETFs emphasising the swings of market permutations does continue to exist, and the volatility experienced by global equity markets last week provided a major test of the appeal of these passive funds. As markets faltered, so did the returns of ETFs, and their appeal (along with that of stock funds in general). Factset, a research provider, estimated that stock ETFs saw outflows of $20.45 billion last week. 

That doesn't show us very much beyond the fact that investors tend to sell stocks (and stock funds) when markets are falling.

There is little indication that ETFs contributed to the market corrections seen so far in February. As observers have lined up to note, ETFs made up a far smaller proportion of the market in 2008, during the global financial crisis, when share prices managed to collapse quite easily without their help. 

Ultimately, the speed of the rise of ETFs is likely to be curtailed to some degree by the volatility markets have experienced. But their fundamental appeal — extremely low fees to get market exposure— remains. Barring a genuine collapse of one of the largest vehicles, it's hard to see ETFs losing their long-term lustre with investors. 

Previous Year of the Rooster retrospectives: 

What will be the best mainstream and alternative asset classes, on a risk-adjusted basis?

Will more countries vote to leave the European Union?

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

How many US rate hikes will the Fed make this year?

Will Donald Trump start a trade war with China?

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