Beware the hidden dangers of exotic ETFs

conexust1f.flywheelstaging.com has partnered with the Thinking Ahead Institute on a regular column of investment insights to provoke thought and discussion among asset owners and managers around the world. This first column looks at ETFs and looks at when an ETF isn’t closely matched by its underlying components, liquidity can dry up, credit risks can emerge, and other factors can eat away at expected returns.  

Since their introduction in 1990 as a cost-effective means of index replication, exchange-traded funds (ETFs) have grown exponentially in number, variety and asset value.

At the end of 2007, before the main market impact of the global financial crisis, there were 1170 distinct ETFs with a total market value of $851 billion. Nine years on, at the end of 2016, the comparable numbers were 6625 funds valued at $3.546 trillion (according to sector researcher ETFGI) – an increase in assets of 317 per cent over the period.

ETFs’ rising popularity stems from several benefits they offer investors: they are cheap (the total expense ratio on State Street’s $139 billion SPDR fund is 9 basis points); they provide exposure to numerous asset classes, industries, geographies, factors and indeed combinations of these; and, in theory, because they are listed on exchanges, they offer a liquid means of building, hedging or shorting a position.

ETFs, however, are not without their risks.

Liquidity issues have emerged in the past, in periods of market stress, and remain contentious.

ETFs are structured to provide liquidity at two levels: through trading on the secondary market (investors trade shares in the ETF like a normal listed share); and through primary market liquidity, when they are liquidated or created from their underlying components.

It is instructive to distinguish between “plain vanilla” and exotic ETFs. In the former grouping, the instrument is closely matched by its underlying components, both in terms of composition and liquidity. Provided the ETF is not so large that its dealings have a market impact, plain vanilla ETFs have proved to be largely robust in the past. Capacity management (the market impact point) is the main issue to watch. Despite some temporary divergences from their underlying indices, these ETFs have, for the most part, been true to their stated objective of providing exposure to their underlying holdings.

In contrast, exotic ETFs are characterised by liquidity mismatches, leverage or both – and it is on these products that concerns tend to focus.

In the event of a sell-off in a high-yield ETF, for example, where liquidity in the underlying bonds has all but disappeared, gaps may emerge between the price of the ETF and that of the index it is trying to replicate.

In theory, the action of authorised participants (APs) in the marketplace should prevent this. APs are incentivised, but not obligated, to make a market in ETF shares and exploit arbitrage opportunities when the price of an ETF diverges from what underlies it. However, given that this involves a parallel trade in the underlying securities, APs may withdraw from the market when the liquidity of the underlying holdings dries up, or there is significant market volatility in the price of the ETF’s components.

Under these circumstances, the price of the ETF may diverge significantly from the stated index price, due to supply of and demand for the ETF in the secondary market.

Synthetic ETFs and counterparties

Synthetic ETFs, which are backed derivatives not physical securities, with investment banks as counterparties, also present some issues.

In many cases, the collateral the counterparties post to the derivative arrangement bears no relation to the assets of the underlying index being tracked. At times of stress, this mismatch exposes the ETF to credit risk from its counterparties.

Aversion to holding the collateral basket or dealing with the counterparty bank may cause APs to stop providing primary market liquidity – again giving rise to potential price discrepancies between the ETF and its components.

There are also market structural reasons why the performance of an ETF may not replicate its target index.

For example, in the case of the Volatility Index (VIX), the ETF will replicate its exposures using forward contracts on the index. Owing to the usual state of contango (upward slope) on the VIX futures curve, long-term holders of the ETF will gradually have their capital eroded, relative to the performance of the index, from paying away the roll yield of the futures.

Leveraged ETFs and rebalancing

Leveraged ETFs present other difficulties. Due to the requirement to rebalance leverage daily, investors using such ETFs to match their exposure to an index may find that after three days of market volatility they have not had the gains or losses they expected based on the performance of the index.

Then there are issues relating to ETF operational structures. Given the predictability of ETFs trading in the market when indices are rebalanced or future contracts are rolled over, there is some concern that they are easy targets for speculators, particularly in times of financial stress.

Ultimately, the outcomes from ETFs come down to how they are deployed. To determine this, we invoke our strategies for coping in a complex investment environment.

Investors need to be clear on their investment objective, have a clear understanding of the strategy they are deploying to achieve this, and be mindful of the other market participants trading in ETFs and how they might be looking to exploit structural features of the products.

Jeremy Spira is senior investment consultant at the Thinking Ahead Institute, an independent research team within Willis Towers Watson.

The Thinking Ahead Institute is a not-for-profit member organisation that was established to change investment for the benefit of the end saver. It has around 40 members, which account for over US$14 trillion in AuM and is administered by Willis Towers Watson’s Thinking Ahead Group, which was launched 15 years ago to challenge the status quo in investment and identify solutions to tomorrow’s problems.