Investors, notbanks, could spark the next crisis
Valued for their simplicity, exchange-traded funds pose worrying risks
Banks must bear much of the blame for previous financial crises. In the next one, ordinary investors could play a more central role.
Ironically, they’ll do so through vehicles created with them in mind — exchange-traded funds, or ETFs. These listed funds are passive by nature, designed to track the performance of an index of stocks, bonds, currencies or commodities rather than to pick and choose among individual companies.
The popularity of ETFs has soared in the past decade. The proportion of US equity-fund assets that are passively managed has nearly doubled in that time to nearly 40 per cent. Vanguard alone owns positions greater than 5 per cent in 491 of the stocks on the S&P 500, adding up to nearly 7 per cent of the index’s total market cap. In Japan, where the central bank owns big stakes in ETFs, passive investors hold over half of all equity assets.
It’s easy to see why such funds have thrived. ETFs, invested in indices that are theoretically diversified, have consistently outperformed active managers. Their simplicity is appealing to lay investors, who can focus on broad assetallocation strategies rather than guessing at individual winners and losers. Costs are low, with fees typically running between 0.05 per cent and 0.50 per cent. That’s become even more important as returns broadly have declined.
ETFs, however, are riskier than many investors appreciate. With capweighted indices, for instance, funds have no choice but to load up on stocks that are already overweight and neglect those already underweight. As prices have risen, investors may become overexposed to a few large securities. That’s the opposite of “buy low, sell high.”
ETFs can replicate indices in complicated ways. Rather than purchasing all the assets consistent with index weights, some funds use a sub-set, thus exposing investors to tracking error. Others use derivatives, creating credit exposure to the counter party. Some ETFs use leverage to enhance returns. Like other funds, ETFs can lend out the fund’s securities to short-sellers, which creates exposure to the return of the borrowed assets. The rules governing indices can be changed, sometimes arbitrarily.
Worse, the ways in which ETFs — by their design and their sheer size — are warping markets aren’t well-understood. ETFs encourage concentration in a few, liquid, large-cap stocks, creating homogenous and momentumfollowing markets. Markets become susceptible to flows from a few, large, passive products.
Artificial factors, such as inclusion or exclusion from an index, forces buying and selling; this can lead to misallocations of capital. In the current equity cycle, for instance, over-weighted, liquid, large-cap stocks have benefited disproportionately from forced buying.
ETFs may even distort valuations outright. For one thing, they don’t analyse prices, meaning that they don’t contribute to price discovery. They arguably weaken corporate activism, as passive owners have little interest in corporate governance.
Finally, ETFs increase volatility and shrink liquidity. Passive funds exhibit significantly higher intraday and daily volatility, driven by arbitrage activity between ETFs and the underlying stocks. With ETFs increasingly important as the marginal buyers and sellers of securities, this may increase volatility in periods of instability.
At the same time, passive funds lock up a large percentage of stocks that can only be traded on changes in market capitalisation or other index metrics. Thus, the actual number of shares available to trade may be a lot smaller than investors realise. Especially when dealing with smallcap shares, certain bonds and commodities, many ETFs are predicated on greater liquidity than is actually available in the underlying assets.
If a crisis does arise, this is likely to exacerbate the downturn. Where ETFs have been the primary buyers, they may have trouble finding anyone willing to purchase the holdings they’re trying to liquidate.
The good times, driven by a confluence of policies favouring passive strategies, have been very good to ETFs. What investors should be worrying about now is how resilient they’ll be when conditions change. In every crisis, untested structures have revealed hidden weaknesses which have threatened wealth and financial stability. There’s no reason to think next time will be any different.