Exchange traded funds offer many advantages to investors but more analysts are questioning whether this fast-growing corner of the asset management business poses a systemic risk to financial markets.
“The rapid proliferation of ETFs is proof positive that investors value their advantages. Yet there is growing concern that the fast growth is a harbinger of instability,” wrote O. Emre Ergungor, senior research economist at the Federal Reserve Bank of Cleveland, in a recent paper.
There is about $1.2 trillion invested in U.S.-linked ETFs.
Ergungor says ETFs have grown so fast because they offer benefits relative to open-end mutual funds and closed-end funds.
Like closed-end funds, ETFs can be bought and sold on the exchange during the trading day. However, they generally avoid the premiums and discounts that can materialize in closed-end funds due to the “arbitrage mechanism” of ETFs. In other words, the price of an ETF share generally trades in line with net asset value.
Meanwhile, ETFs can be more attractive than open-end mutual funds “because the fund manager does not have to keep cash on hand to meet redemption requests and because the shareholders do not suffer from taxes and transaction costs arising from other investors’ trading.”