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ETFs under the microscope

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Beverly Chandler charts the rise and risks of the ETF, both for retail and institutional investors.

Assets in exchange traded funds (ETFs) continue to soar with industry data provider ETFGI reporting that 2015 saw global ETF/ETP net new assets reaching a record level of USD372.0 billion, a 10 per cent increase over the prior record of USD338.3 billion of net new assets gathered in 2014. 

A recent study, ETFs in the European Institutional Channel, from Greenwich Associates and commissioned by BlackRock, found that the next 12 months will likely bring increases in both adoption rates and the overall amount invested in ETFs. 

Approximately a quarter of Continental European institutions and 20 per cent of UK pension schemes invest in ETFs, and 17 per cent of institutions on the Continent not currently investing in ETFs, plan to start using the funds in the next year. Over the same period, more than a third (35 per cent) of investors in Continental Europe plan to increase their investments in ETFs.

In less than 20 years since their inception, ETFs have proved increasingly popular with both institutional and retail investors due to their transparency, liquidity and low cost base. 2015 saw them overtaking hedge funds in terms of assets under management as the more active funds struggled to provide returns that would justify their high fees.

The ETF industry started in the US and the industry there still remains different from the ETF industries that have launched elsewhere in the world as the product has continued its inexorable spread. 

Curiously, 2015 saw net new assets into US ETFs drop, while European funds saw net inflows climb to USD82.0 billion, representing a 45 per cent increase on the record set in 2014, according to ETFGI.

“There is a different landscape between the US and Europe for ETFs with a 50 per cent retail and 50 per cent institutional investor base in the US, while in Europe, retail is just 20 per cent and investors are predominantly institutional,” says Howie Li (pictured), co-head of Canvas, a platform that offers asset managers the ability to launch white-labelled ETFs in Europe, at USD14 billion ETF Securities.

Mohit Bajaj, Director of ETF Trading Solutions, WallachBeth Capital, agrees: “ETFs are becoming a global phenomenon,” he says. “The US makes the lion’s share and Europe is a close second, but now we hear stories about India or more Asian countries launching ETFs because it’s a cheaper vehicle than the typical mutual fund and operationally easier to manage one position rather than a number of positions.”

The strength of the retail ETF business in the US lies partly in what Li sees as a widespread personal investment culture in the country. “In Europe, there is more of an advisory model for retail investors and, specifically in the UK, independent financial advisers have a strong business and people trust their advisers to give them advice on asset allocation, whereas in the US, there is a stronger do-it-yourself attitude, with investors happy to understand the world of investments.”

In Europe, particularly again in the UK, there are infrastructure issues for ETFs where independent financial adviser platforms often cater more for mutual funds. This has changed post the UK’s 2013 Retail Distribution Review which was designed to encourage transparency on the cost of investing by the investor, and to stop financial advisers being remunerated through commissions rather than fees. 

If an IFA is being paid a fee for advice, rather than taking a commission, ETFs and mutual funds move onto a level playing field.

Li says: “ETFs are here to stay, the way they are structured means that the assets in the portfolio of an ETF and a UCITS mutual fund are the same, the only difference is that the ETF has an additional layer of liquidity as it is traded on an exchange allowing investors to trade intraday.”

But turning from the retail investor, who is definitely part of the upswing in assets in ETFs in Europe, to the institutional investor, what participants in the industry are seeing, is institutional money actively moving over from active management to passive.

Nizam Hamid is head of sales at WisdomTree Europe which has benefited in the growth of assets in ETFs over the past year, having seen their assets go up from USD160 million to USD800 million in one year. 

“Institutions have a lot of core exposures to equity and fixed income indices and have come down to single basis point costs because it’s cheaper to trade in ETFs and manage the risk in terms of running futures positions,” he says. 

Bajaj agrees: “More institutions are coming into ETFs. In fixed income, ETF managers don’t have the bandwidth to monitor or access certain types of markets so you will see institutional investors who want exposure to emerging market bonds, for instance – they will buy the ETF.”

Adriano Pace, Director, Equity Derivatives at Tradeweb, says: “We are definitely seeing more interest from institutional investors, whether it’s existing clients increasing their use of ETFs or new clients trading ETFs on the platform for the first time.”

Not content with taking all the money, ETFs themselves have evolved and are increasingly offering a product that is less vanilla, and one that is taking the active managers on in their own arena – the smart beta ETF. 

“Smart beta takes some of the expertise of active managers and puts it into a systematic or formulaic process to help produce something additional such as lower volatility or alpha over the market-cap equivalent within the ETF,” explains ETF Securities’ Li.

WisdomTree’s Hamid says that there is definitely an increase in demand from institutions for ETFs that offer something slightly different. “We are getting more enquiries from institutions as we do focus, on the ETF side, on being different from market cap weighted indices, providing alternative and fundamental weighted strategies,” he says.

WisdomTree Europe’s co-CEO Hector McNeil recently published a note on this very issue, predicting that next year will see a greater focus on performance in ETFs. “The pricing of core ETFs has already arguably won the battle with mutual funds when it comes to the provision of passive trackers. Now we are seeing a shift in focus in terms of investor expectations as they become more aware of the opportunities and breadth of asset management benefits the ETF wrapper can deliver for them,” McNeil says. 

“We are yet to see this focus on performance after fees in the ETF space to the same extent as exists in the US, but as smart beta picks up momentum in Europe, we believe it to be the direction of travel over the next few years.”

McNeil believes that rather than focusing on whether they can get US equity exposure for 4bps or 5bps from different providers, it will be the type of exposure investors are getting which will become more important.

Tradeweb’s Pace says: “Fees are coming down, even within the ETF sector due to competition among issuers. Every month there are several examples of mainstream ETF issuers either lowering total expense ratios in existing funds or launching a new range of products with more competitive expenses.”

WallachBeth broker, Bajaj explains that mutual funds still raise assets because people bet on the track record of the fund managers. “Smart beta funds try to have all these technical points to outperform the market but many don’t have the track record that a fund manager does, so they depend on back testing for marketing themselves. With ETFs, there are only so many ways you can reinvent the S&P 500 so they have to draw on smart beta to gain traction,” he says.

The track record issue is one that WisdomTree’s Hamid comments on as well. “Some parts of the smart beta universe are overly complex,” he says. “We have live indices and live track records since 2006 so we are heading to a ten year track record which is different from people who are creating smart beta back tested strategies today. Understanding how strategies work in the real world is something that clients put a lot of store in.” 

And in August 2015 in the US, the real world stepped in to give a short view of what can go wrong with ETFs.

James Angel, Associate Professor of Finance at the McDonough School of Business at Georgetown University, who is writing a paper on the subject, explains what happened. 

Under the normal conditions that prevail 99.985 per cent of the time, ETF prices track the underlying assets with amazing fidelity because arbitrageurs are constantly monitoring the prices of ETFs and their constituents, he says. 

“If they get out of line, the arbitrageurs buy the cheap side and sell the expensive side in order to pocket the difference. This arbitrage activity keeps the prices of the ETFs locked very closely to the price of the underlying assets. However, during times of market stress such as during the Flash Crash of 2010 and the first 90 minutes of trading on August 24, 2015, this can fall apart.”

The SEC’s Equity Market Trading Volatility Report on what happened that day reveals that ETPs as a class were particularly affected, experiencing a larger number of extreme price declines than Corporates (individual stocks).

The report says: “For example, 19.2 per cent (288) of ETPs experienced price declines of 20 per cent or greater, while only 4.7 per cent (280) of Corporates experienced such declines. Trading volume surged and displayed liquidity dropped, particularly at the open, in Large, Mid, and Small ETPs.”

Some 83 per cent of Limit Up-Limit Down (LULD) halts on August 24 were in ETPs, even though they represent less than 20 per cent of the securities subject to the LULD Plan that were traded that day, the report says.

Angel explains that computerised arbitrageurs have automatic risk controls in place so that they stop trading when something is going haywire. 

“These risk controls include simple things like ‘Is my connection to the exchange functioning?’ and ‘Does the data I am getting from the exchanges make sense?’ If their automated systems detect a problem, they shut down automatically, which is exactly what one would want them to do. From time to time the market can be so chaotic that the automated arbitrageurs stop trading. Without the arbitrageurs, the prices of the ETFs can and do drift away from the prices of the underlying assets. On 24 August, there were thousands of ETF trades that took place at prices more than 20 per cent away from the price of the underlying assets held by the ETFs,” Angel writes.

WallachBeth’s Bajaj says: “The August incident was skewed but ETFs performed the way they are supposed to. Negative sentiment overseas caused US stocks to halt and many ETF marketmakers didn’t know where to price these funds. To protect themselves they put low bids out and offers were high because they didn’t know how to price the ETF. So retail investors who sold in the market without using a limit, those market orders hit those low bids. It was just a few thousand shares that traded at those levels, but caused the prices to drop dramatically once those bids got hit out.”

WisdomTree’s Hamid comments: “What has been slightly overblown was that it was all ETFs, but it wasn’t. Most didn’t experience a trading halt on that day. The trading halts that happen in the US apply not only to ETFs, but also to the underlying securities, so problems in the underlying securities impacted ETFs.”

“During large market correction events such as 24 August and 14 December 2015, activity tends to grow,” says Tradeweb’s Pace. “On 24 August, more than EUR1 billion of notional volume was traded on the platform, twice the amount we would normally see. There were lots of large block trades from investors exiting their positions, and yet their ability to execute was not diminished in any way. This is good news not just for the platform, but for the ETF industry as well.”

The SEC report says that there was a wide variation among ETPs in their volatility and number of LULD halts. Their analysis shows that most ETPs (859 or 63.3 per cent of total ETPs) experienced price declines of less than 10 per cent, a level that is generally consistent with the broad-market price declines on 24 August and therefore, the SEC says, suggestive that they traded with little, if any, discount to the indices they were designed to track.

The report found that most ETPs (1,226 or 80 per cent of total ETPs) did not experience even a single LULD halt on 24 August, but the 315 ETPs that did experience an LULD halt at an average of 3.3 halts per ETP. The report also found that SPY, the largest ETP that tracks the S&P 500 index, traded in line with or at a premium to SPY NAV, while IVV, the second largest ETP that tracks the S&P 500 index, traded at a substantial discount to SPY, SPY NAV, and E-Mini in the opening minutes of 24 August.

Many NYSE-listed Corporates did not open on NYSE at 9:30 and their delayed opens potentially could have affected trading in ETPs designed to track indexes that include NYSE Corporates (such as the S&P 500). Nevertheless, all NASDAQ-100 constituents are listed on NASDAQ and opened on NASDAQ at 9:30, and still the highly active QQQ traded at a substantial discount to QQQ NAV in the opening minutes of 24 August.

It could happen again, says Professor Angel. “This happened during the Flash Crash of 2010 and again on 24 August, 2015. It will happen again during a time of extreme volatility. The automated risk controls of the arbitrageurs will push the arbs to the sidelines and prices will become uncoupled from the underlying ETF assets.”

But more optimistically, Angel believes it can be fixed, and quite simply. “ETFs publish ‘intraday indicative values’ (IIVs) every 15 seconds during the day with their estimate of the underlying value of the stocks. Any investor can see these from standard data sources. This IIV should be the basis for the Limit-Up-Limit-Down (LULD) circuit breakers that are used to prevent excessive movements in stocks. Right now, the US markets prohibit trades outside of a band surrounding a ‘reference price’ based on the last five minutes of trading. If we made the reference price the IIV, we could guarantee that the ETF prices would never deviate more than a few percentage points from the value of the underlying assets,” he says. 

Both institutional and retail investors should be aware that ETF prices can deviate from the underlying values in times of stress, Angel believes. “My recommendation is to always check the IIV, and use a limit order when placing a trade to make sure that you don’t get killed by market volatility.”

So far the flash crash and price variations have been a phenomenon limited predominantly to the US, but Angel believes that it could happen in other countries, and some fund managers are now expressing concerns on the rapid growth of the ETF market. 

Sandra Crowl, member of the investment committee, for EUR52 billion AUM Carmignac Risk Managers says that while in most cases investors have been able to access large equity stock markets through ETFs, there are some technical aspects that merit highlighting as a warning to users.

“Approved participants (AP) have the responsibility to create and redeem ETF contracts according to supply and demand of large lots in the primary market. They arbitrage to keep the net asset value of an ETF reflecting the underlying assets of its index. Smaller investors use the secondary market and as long as there is a nice balance of ‘sells’ and ‘buys’ the process works appropriately. The liquidity offered also depends on how many Approved Participants there are, the more there are, the better the price liquidity in practice,” she says.

“However, as volatility in some markets rises and vulnerable physical markets shrink compared to the ETF offering, a divergence in the net asset value with the physical market may ensue. If the AP cannot transact some components to recreate the price of the physical market easily during its high velocity rebalancing when there are periods of one way orders, then spreads can widen or gap.

“The liquidity of an ETF is as good as the underlying market. Emerging equities, US High yield and commodity markets have seen some massive outflows over recent months. And this comes after some untimely inflow into Chinese and Japanese equity ETFs at the start of last summer. Leverage, one way bets and lower USD funding available is a perfect storm for ETFs covering these particularly high beta markets. And indeed we have seen a recent suspension of a leveraged Japanese equity tracker.”

Crowl believes that the market is not that transparent given liquidity on a screen is not representative of the total liquidity for a single ETF. “The APs have the hand and control the creation and pricing mechanism. Fortunately these bodies are regulated and more transparency has been requested over recent years,” she says.

Crowl also demurs on smart beta funds, saying: “ETFs are primarily used on stock and bond indices to give directional risk, subject to the market volatility and liquidity. Investors take on that risk and must manage it. It is in stark contrast to a non-benchmarked, flexible fund management approach. In a bid to diversify, ETF issuers have created smart beta and factor ETFs touted to provide some ‘smart’ alternatives, but the investor may be in fact concentrating his bet on a single factor like one single sector or style which may offer more tail risk than they were hoping for.”

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