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Are ETFs a harbinger of doom for the markets?

Are ETFs a harbinger of doom for the markets?

ETFs have no shortage of fans but when detractors gather, the charge sheet is extensive.

Some accuse them of being worse than socialism, others say they divert capital to the biggest rather than the best securities. Soon enough we will have people blaming them for climate change.

Then there is the belief among some that as ETF inflows soar, they are bound to ramp up markets to new highs (as is happening now) which are unsustainable and will surely lead to a massive crash.

Guilty as charged? Industry experts have argued against this theory, saying that ETFs are liquid and transparent, and if the market tanks, all boats will go down together.

Hortense Bioy, director of passive research, Europe, at Morningstar, holds to this belief.

‘ETFs are not an asset class. These products are backed by physical assets, so they are just like mutual funds, except they trade on exchange.’
Despite a recent flurry of headlines questioning the robustness of ETFs during volatility, these passive funds in general have experienced few calamities since launching almost 20 years ago in Europe and since 1993 in the US.

Lessons of history

In 2000, when iShares launched its first two ETFs in Germany, commentators doubted the funds’ success, arguing the so-called Y2K bug could bring down civilisation. The iShares Stoxx Europe 50 UCITS ETF and the iShares Euro Stoxx 50 UCITS ETF now have combined assets of more than €6.5 billion.

Peter Sleep, senior portfolio manager at 7IM, said any future market weakness was more likely to be caused by human behaviour than by ETF structure.

‘We have always had volatility and investment bubbles, and we will always have volatility and investment bubbles in the future, regardless of the chosen investment route,’ he said. ‘The criticisms of ETFs are really, at heart, criticisms of investors as being human.’

ETFs survived the tech bubble in the early 2000s, and the financial crash of 2008. Many investors remember, however, when a Europe-listed ETF tracking Greek equities shut down in 2015 for five weeks as the Athens stock exchange suspended trading during domestic volatility.


But even then, when the Lyxor UCITS ETF FTSE Athex 20 shut its doors, its US-listed counterpart continued to trade.

This was a rare example. During that same period in 2015, more than 14,000 Chinese companies suspended trading to stem panic selling, but China ETFs continued to trade. And after the Brexit referendum in June 2016, several actively managed property funds trapped investors’ cash for weeks, while ETFs, which tend to replicate equity-based real estate investment trusts, kept trading.

More concerns are levied towards the US, which holds the lion share of ETF assets. Dave Nadig, CEO of ETF.com, pointed out that ETFs now represent 30 per cent of dollar trading volume – although the percentage is not as large globally.

‘Structurally, ETFs allow information to be acted on very quickly across asset classes. That means these kinds of shifts in investor sentiment simply happen more quickly, and pricing re-settles at new sentiment-based prices faster,’ he said.

‘Since you measure volatility over a timeframe, the shortening of that time frame means new information causes volatility. But the underlying market plumbing is solid, and I don't foresee the kinds of ‘breakages’ that get talked about.’

Flashback

Although the US Securities and Exchange Commission said ETFs played a significant part in the flash crash of 2010, with 68 per cent of more than 21,000 cancelled trades coming from ETF investors, Sleep disputed concerns that ETF investors were more likely to run away at the first sign of volatility.


‘I am not sure ETF investors are particularly prone to irrationality more than any other investors,’ he said.

A decade after the last financial crisis, boom and bust economic theory predicts another collapse is inevitable, but that could benefit ETFs, according to Nadig. Vanguard and Morningstar found that in the last decade in the US, more than $1 trillion has shifted from active to passive US equity funds.

‘When the market does eventually sell off, and we all know someday it will, ETFs will be down, just like everything else,’ he said. ’And then when the markets bottom, money will continue to flow out of underperforming low-conviction active funds into low cost ETFs. We've seen it after every market pullback.’

 

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