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.”
However, Ergungor wonders if the evolution of ETFs has resulted in new dangers for the market.
For example, the May 2010 Flash Crash “showed how ETFs can potentially cause contagion across markets.” Many ETFs saw their shares plunge in value and had their trades cancelled by regulators, although they found no evidence that ETFs caused that day’s extreme volatility.
“The weakness that led to the Flash Crash may be the fragmented nature of trading in the U.S. stock markets, not the design of ETFs,” Ergungor wrote.
Leveraged and Synthetic ETFs
The Fed economist also singled out so-called synthetic and leveraged ETFs. Rather than holding a portfolio of securities such as stocks and bonds, these funds invest in a third-party’s promise to deliver an asset or a stream of cash flows rather than the actual asset itself, Ergungor notes. [Leveraged ETFs on the Hot Seat]
“These synthetic products introduce counterparty risk—the risk that the third party won’t or won’t be able to honor its obligations—which is not an issue for plain vanilla ETFs. Because synthetic securities are not backed by the actual asset, they can be created in unlimited amounts, potentially creating exposures much larger than the underlying asset market. For additional flavor, investors can spice up their expected returns by investing in ETFs that augment the gains from the underlying assets using leverage—investing with borrowed funds. Unfortunately, as the failures of Bear Stearns and Lehman Brothers have shown, leveraging also magnifies the losses,” he wrote.
“There is no indication that the use of synthetic and leveraged ETFs will reach levels that could threaten financial stability any time soon. We continue to believe that very important lessons about investing have been learned in the last five years, and those lessons will keep a cap on investors’ risk appetites. Still, regulators will be staying alert, just in case,” Ergungor concluded. [What Regulators are Looking at in ETFs]
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