The growth of exchange-traded funds and passive investing since the financial crisis has been so huge they could unwittingly be central to the next major market downturn.
The structure and size of ETFs, together with the trend-following nature of passive funds, mean the breadth of selling from this investor base when the market does turn south could quickly accelerate.
To date, this hasn’t happened. Although bouts of market turbulence in recent years have led to corrections of 10 per cent or more on Wall Street, the sell-offs all proved short-lived.
Worries about the collapsing oil price in 2014, fears over China’s banking system in 2015 and concern over a U.S. economic slowdown in early 2016 all pushed the S&P 500 down at least 10 per cent before the upswing to fresh highs resumed.
Richard Turnill at BlackRock Inc. – the world’s largest asset-management firm, which runs some of the world’s biggest ETFs – said one of the main reasons markets survived these rocky rides was precisely the liquidity provided by ETFs.
In each of these episodes ETF liquidity arguably held up better than their underlying constituents, and the vehicles themselves provided greater price discovery. Liquidity is “a good thing and reduces the risks of financial stresses,” Mr. Turnill reckons.
Yet there was no shortage of liquidity sloshing around every conceivable corner of world financial markets in 2007, and that didn’t prevent the financial tsunami that followed the next year. Indeed, the opaqueness of derivatives markets and off-balance-sheet investment vehicles played a major role in the 2008 crisis.
ETFs were originally designed as investment vehicles for retail investors and households. But large institutional funds and asset managers are taking over, and the scale of money involved means these products can move markets much more easily.
Blackrock pulled $140-billion (U.S.) into its ETFs in the first half of this year, more than the total for all of last year. More than $80-billion has poured into Vanguard ETFs, well on course to beat last year’s record $97-billion.
Although they have survived a few market scares in recent years and even thrived subsequently, ETFs are essentially untested. They came to prominence after the 2008 crisis and there hasn’t been a market shakeout anywhere near that magnitude since.
‘Liquidity is a coward’
A question mark remains over whether ETFs have the inventory of underlying stocks to back them up in times of crisis. In 2008, a whole slew of derivatives and over-the-counter financial products and investment vehicles were simply priced at zero when the market froze.
That wasn’t because they were worth nothing, but because there was no price visibility and so had to be marked down to zero. Would the same apply to ETFs in a crisis?
The nature of ETFs and passive investment is worth noting. A vanilla S&P 500 ETF, for example, effectively puts company and sector fundamentals to one side and buys or sells 500 stocks at a time. This is fine in a rising market, but potentially dangerous in a falling market.
ETFs are becoming much more complex, too, with some of the more exotic products using a combination of underlying securities, swaps and derivatives to boost returns. They are untested yet, and could unravel in a major sell-off.
The longer ETFs and passive investments mushroom in size, while implied volatility remains anchored at historically low levels, the more the risks grow.
Some of the numbers are huge. U.S. stock market trading volume is now 24-per-cent ETFs and 76-per-cent single stocks, compared with 20 per cent and 80 per cent only three years ago, according to Merrill Lynch.
Vanguard’s share of the overall S&P 500 market cap has doubled since 2010 to 6.8 per cent today, and the share of passively managed U.S. equity-fund assets has nearly doubled to 37 per cent today from 19 per cent in 2009, Merrill estimates.
These shifts bear monitoring because they suggest the amount of shares in the hands of non-passive investors is smaller than thought. This isn’t a problem until it is; when the selling snowballs, there are suddenly not enough buyers and liquidity isn’t as deep was assumed.
And it remains unclear whether, in a major sell-off, ETF liquidity will be backed up by their underlying securities. According to Mark Yusko at Morgan Creek Capital Management, “liquidity is a coward, it only exists when you don’t need it.”
Mr. Yusko points to investment trusts of the 1920s, products aimed at U.S. retail investors that exploded in popularity during that decade but ultimately helped bring about the 1929 market crash.
The modern day equivalent? ETFs, Mr. Yusko reckons.
Jamie McGeever is a columnist with Reuters.Report Typo/Error