ETFs: The Systemic Risk Compass

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“The thing that worries me most is an ETF providing an investor unintended exposures in their portfolio.” — Ashley Cooke, head of ESG solutions and passive, institutional client coverage, DWS Xtrackers

“Accelerated events to the downside . . . are not unique to ETFs. It’s any type of concentrated investment. When people hit the exit button, the speed of trading, as fabulous as it is, it doesn’t give us time to think.” — Ed Coughlin, director of trading services, NASDAQ

“The question is whether the ETF will either cause or exacerbate a stock market panic or crash, whether it will contribute to the speed of contagion.” — Kurt Schacht, CFA, managing director, Standards and Advocacy, CFA Institute; member, The Systemic Risk Council

“We got comfortable with liquidity by talking to some of the ETF market makers about how they operate, how they hedge, and make markets on these.” — Wen-Fu Wu, managing director, head of asset allocation and portfolio construction, General Account portfolio, TIAA

Do exchange-traded funds (ETFs) pose systemic risk? Or are such concerns exaggerated?

These questions have come increasingly to the fore over the last several years. It’s not hard to see why: It’s been more than 10 years since the outbreak of the global financial crisis (GFC), and the current bull market, the longest ever recorded, is, safe to say, in late-cycle territory.

This combination of concern over the next downturn — what could set it off, spread it, or push it into severe crisis territory — and massive inflows into ETFs has led some, Moody’s Investors Service and Michael Burry, of The Big Short fame, among them, to sound the alarm.

With these issues in mind, and ahead of the ETF Synapse Conference 2019 on Friday, 22 November, CFA Society New York, with support from CFA Institute, convened a panel of ETF experts. Representatives from all points of the ETF industry compass — institutional and private wealth investors in ETFs, ETF issuers, market makers, and exchanges — shared their insights with academic researchers about ETFs and their associated risks. Front of mind in this dialogue was the question of what is and isn’t an ETF, as well as whether there’s anything unique to ETFs that makes their risks distinct in type and magnitude from those of other securities.

Jayesh Bhansali, CFA, of the Gabelli School of Business at Fordham University, who chaired the panel, described the current ETF landscape in his opening remarks:

“ETFs have grown substantially in size, diversity, scope, complexity and market significance in recent years. Even though they still account for a relatively small portion of the total market cap, about 10% to 12% I recall based on a recent study, however, the average trading volume is north of 30%, which is relatively a pretty large number.

“While most ETFs track liquid equity indexes, one of their key features is related to the capacity to also replicate baskets of less liquid assets and form more liquid tradable surrogates. But as we all know, this so-called magical liquidity transformation has a tremendous friction cost attached to it.”

He went on to quote from a Moody’s report:

“‘The ETF market has grown rapidly during a period of relative calm, meaning that it has yet to be tested by a period of high market distress or volatility. Unexpected market liquidity shortfalls could be most pronounced with an ETF tracking inherently less liquid markets such as high-yield credit.’

“The report further adds, ‘These ETF-specific risks, when coupled with an exogenous system-wide shock, could, in turn, amplify systemic risk.’

“Hence,” Bhansali concluded, “the significance of this topic.”

What Is (And Isn’t) an ETF?

To understand their risks, we first have to understand what ETFs are. Investment funds composed of systematically selected securities that trade on exchanges doesn’t really describe the ETF universe in all its nuance. Indeed, there are surprising knowledge gaps among the general public and even within the finance sector about what these securities are.

“Where people get confused sometimes is when they think of ETFs as an asset class,” said Samantha Merwin, CFA, who leads public policy efforts for iShares global markets at BlackRock. “ETFs are not an asset class. ETFs are an investment wrapper. They’re a tool that allows investors to access the underlying asset classes.”

That sounds pretty simple. But there remains considerable uncertainty and some have advocated assigning the ETF label to potentially questionable products.

“One of the weaknesses in the industry is that there isn’t a good classification around what an ETF is and how it sits in the marketplace,” said legendary ETF market maker Reggie Browne, principal of GTS. “I think that’s a weakness that needs to be addressed. You have folks out there advocating for bitcoin, diamonds, and other esoteric asset classes that don’t belong in the ETF industry.”

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Risk: Systemic and Otherwise

To determine whether the risks associated with ETFs could be systemic in nature, the panelists also had to define what they meant by systemic risk.

Mark Hoffman, PhD, CFA, of PNC Financial Services Group and head of portfolio management for PNC’s asset management advisory businesses, laid out an effective working definition.

“What I think about is material, sustained, and widespread losses due to some sort of market breakdown,” he said. “So if it’s something like the Flash Crash where it’s a matter of a couple of hours, or if it’s something that’s going to be reversed, or it’s sitting out in some esoteric market, we’re not thinking about that as systemic risk per se.”

So what role could ETFs potentially play in market downturns?

For insight on this, Ayan Bhattacharya, PhD, of Baruch College, City University of New York, who co-authored the forthcoming CFA Institute Research Foundation monograph ETFs and Systemic Risk with Maureen O’Hara, PhD, of Cornell University, shared his perspective.

“First off, ETFs are great things,” Bhattacharya said. “Asset pricing theories would say that investors should hold fully diversified portfolios. That’s in theory. But in practice, retail investors, other investors, can’t do that because most of the market is not accessible, assets are too costly, and so on. So ETFs have helped to solve some of those problems.”

But he did highlight some ETF-related concerns. While many of those he described as typical of all passive investments, others were not. He spoke particularly about ETFs’ heightening effect on market movements, a phenomenon documented by academic research.

“There’s a set of issues that are unique to the ETF because of the structure of the ETF that has to do with the amplification of market movements,” he said. “Especially during times of market stress and uncertainty.”

While most panelists acknowledged that ETFs were hardly risk free, they questioned Bhattacharya’s suggestion that ETFs had an especially distinct risk profile or an amplification effect. Certainly, they agreed that liquidity risk was a concern both for themselves and their clients.

“We have a lot of discussions with clients around liquidity,” said State Street’s Bill Ahmuty, head of SPDR fixed income. “How do you know if an ETF is liquid, and what’s driving that liquidity from the primary and secondary markets?”

“It’s really the liquidity of the underlying exposure,” said Stephanie M. Pierce, the CEO of BNY Mellon Investment Management’s ETF and index business. “But it’s not unprecedented to see a liquid investment vehicle with illiquidity underneath it.”

“Liquidity is obviously the prime concern for us,” Hoffman concurred. “We’re always looking at the liquidity of the underlying, doing our best to understand how much of a liquidity mismatch are you taking on, and that’s going to tell you what your bid–ask spread and what the spread between the net asset value and the price of the ETF are going to be in the market during periods of stress.”

Since liquidity risk is an issue for all kinds of securities, especially those that have an illiquid asset underneath a liquid one, participants did not see that as ETF-specific. In fact, they found such concerns were much less pronounced for ETFs than for other products.

“With so much attention on the risk of the ETF structure, it’s surprising to me that many investors and advisers overlook most related risks with mutual funds,” said John Penney, CFA, a senior advisor consultant for Invesco’s registered investment advisor (RIA) division. “ETFs can, in fact, alleviate some friction that mutual funds may experience during periods of volatility and heavy selling.”

Indeed, some panelists suggested the visibility that ETFs provide means that they are under more of a microscope. Less transparent securities that may have greater systemic risk potential receive less scrutiny simply due to their opaqueness.

“There’s 29 years of empirical evidence globally about how ETFs behave through all market events. That empirical evidence is enough to close down the ongoing conversations around ETFs being catalysts for some system-wide event,” Browne said. “While you have ETFs, you have SMAs, you have mutual funds, you have CITs. You have so many different structures that use underlying assets. ETFs, because they’re transparent, everyone’s pointing to the ETF structure as being the catalyst. But yet, it’s a vehicle for true transparency in real time.”

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“Know What You Own”

Whatever their perspective on the potential systemic risk implications of ETFs, all the panelists underlined the importance of education.

And much of that came down to a simple concept: What Pierce referred to as, “Know what you own.”

“‘Know what you own’ is a concept we educate many clients on,” Ahmuty added. “We focus a lot of resources toward educating people on ETF mechanics, the importance of liquidity, and how it all impacts total cost of ETF ownership. What we find is that actually lots of people need help understanding what they own, even sophisticated investors.”

ETFs are a relatively new innovation and they continue to evolve. As their use cases expand, as with any security, so too will their potential risks. So the more knowledge — among professionals and the public — the better.

“I consider myself almost a 20-year ETF novice,” said Steve Oh, head of ETF Listings at NASDAQ. “I use that word because our industry is growing rapidly. Even the experts in this room have to keep up with what’s going on.”

For more on exchange-traded funds (ETFs), don’t miss A Comprehensive Guide to Exchange-Traded Funds (ETFs) by Joanne M. Hill, Dave Nadig, and Matt Hougan from the CFA Institute Research Foundation.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©Getty Images/combomambo


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Paul McCaffrey

Paul McCaffrey is the editor of Enterprising Investor at CFA Institute. Previously, he served as an editor at the H.W. Wilson Company. His writing has appeared in Financial Planning and DailyFinance, among other publications. He holds a BA in English from Vassar College and an MA in journalism from the City University of New York (CUNY) Graduate School of Journalism.

Paul Kovarsky, CFA

Paul Kovarsky, CFA, is a director, Institutional Partnerships, at CFA Institute.



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