'A huge risk of contagion': Everything you need to know about ETFs -- the hot investment area that some think will cause the next financial crisis

  • Exchange traded funds have grown 500% in value since 2008 to $US4 trillion.
  • ETFs have never been prevalent during a downturn, so there are fears that once the market turns, things might get messy.
  • Bond market guru Mohamed El-Erian says ETFs pose a “huge risk of contagion.”

LONDON — When the American Stock Exchange launched its S&P 500 Depository Receipt
fund in 1993, no one could have foreseen the path it would lay for the future.

The fund was nicknamed the “spider” because of its ticker symbol, SPDR, and is now considered to be the first successful launch of an exchange-traded fund. Fast forward 25 years, and the global market value of such funds is more than $US4 trillion and growing.

An exchange-traded fund is a passive fund which tracks an index, rather than an active investment, and seeks to outperform a given index through frequent buying and selling of individual investments.

In 2017, ETFs exist for virtually every imaginable asset class, with investment firms selling ETFs in everything from Bunds to Bitcoin.

Investors have poured money into the products in the past handful of years because when the times are good, ETFs can offer much larger returns than simply investing in underlying assets, or putting money into actively managed funds, which tend to have much higher fees than ETFs.

That outperformance can come from leveraged ETFs, which essentially rely on a cocktail of debt and derivatives to increase the returns on an investment. For example, if the value of bitcoin were to increase by 5%, a three times leveraged ETF could see returns of 15%. The downside to this is that in a down market, losses are also amplified by the same ratio.

Since 2008, the value of the global ETF market has ballooned by five times, and was described as “extraordinary,” by Deutsche Bank’s renowned strategist Reid and his team in a recent note.

“Putting the numbers in perspective, including ETPs (which make up a much smaller percentage), the global AUM of exchange traded products (all asset classes) is now over $US4tn. This compares to around $US800bn or so in 2008,” Reid said in the 2017 edition of Deutsche Bank’s Long Term Asset Return study.

Here’s the chart:

ETFs have drawn their fair share of criticism, especially from the managers of active funds — many of who are understandably annoyed at having business taken away from them and put into ETFs.

Paul Singer, the head of Elliott Management Corporation, a hedge fund specialising in distressed debt, for example, said in July this year that passive funds like have the potential to be “destructive.”

“What may have been a clever idea in its infancy has grown into a blob which is destructive to the growth-creating prospects of free-market capitalism.”

And no one knows how they will perform when demand for them goes into reverse.

“The trouble with ETFs is that they have never really been tested in a downturn so the thing is we don’t know [what will happen],” Peter Dixon, the chief UK economist at Commerzbank told Business Insider.

Why people are worried

The fear is that ETFs have created their own bubble-like momentum: As ETF returns have beaten active managers, more money has gone into them. As more money goes in, the price of the stocks being bought rises. Those rising values attract more money, and so on. ETF investors don’t care whether stocks are over-valued, only that they’re buying a representative slice of the market.

That has prompted well-known money managers to warn of the effect of passive funds on asset prices, and the danger of a liquidity squeeze when the market is under pressure.

And therein lies one of the biggest issues being flagged about ETFs right now. They simply haven’t been tested in a down market.

ETFs have grown rapidly, but their resilience has not really been tested by any significant market hardship, leading some observers to question if the sector will be able to cope with a substantial market correction should one come in the near future.

This is especially true when considering that some believe ETFs can distort the markets by encouraging investors to put money into big companies — simply because they’re big names — regardless of their market fundamentals (things like price-earnings ratios, return on equity etc.)

Here’s the explanation from Jim Reid and the rest of his team at Deutsche Bank last month (emphasis ours):

“One argument is that passive investing naturally favours large caps when picking constituents based on factor style (for example momentum, growth etc). In theory this means that the biggest companies are getting bigger, regardless of fundamentals.

The concern therefore being that these companies are perhaps more susceptible to overvaluation and the gap between the small/mid to large caps also widening. This could potentially mean that risks are amplified when you see a big market correction, which arguably ETFs haven’t yet been tested with yet.”

Stocks, particularly in the USA, have been going up and up over the last few years, and in 2017 have seen frequent record highs. This year alone the Dow Jones Industrial Average has passed above 20,000 points, while the S&P 500 has also reached never before seen levels.

In Europe, both Britain’s FTSE 100 and Germany’s DAX have also broken to new all-time highs frequently this year, while other assets like bitcoin have also surged.

In short, ETFs have been able to thrive during a time of great expansion for the markets, but what happens when things almost inevitably start to reverse course and markets start to drop is an unknown right now. According to recent analysis from Goldman Sachs, the probability of stocks entering a bear market — where stocks drop 20% from a peak — in the next 24 months currently stands at about 88%, based on the history of previous bear markets.

A coming storm

So, there’s a good chance a market correction is coming, but how will ETFs weather the storm? The short answer is that no one really knows.

Peter Dixon, the Commerzbank economist, told Business Insider, “My concern would have to be that they give the impression that there’s lots of liquidity out there. But if everybody is trying to get out at the same time, the question has to be, do ETFs exacerbate or magnify the impact of the decline?”

Jim Reid does point to one small test of ETFs — around 18 months ago drop in the oil price caused a sell-off in the high yield bond markets. Some believe that ETFs made that sell-off worse, while others believed ETFs helped provide liquidity to the market, preventing a worse correction.

“In reality,” Deutsche Bank’s argument goes, “ETFs and ETPs have not yet been fully tested in a sustained bear market. So the real test could be when we see the next downturn and these products are faced with heavy redemptions. This will be particularly paramount for less liquid asset classes.”

People could get badly “burned” once a market downturn does come, Dixon said.

“They’re bubbly, and might have also contributed to the recent rally in equities anyway, because everyone is jumping into them.”

“I’m just a bit concerned that if and when equities themselves turn around, and they might if US rates start to rise rapidly, you might start to see people starting to get burned,” he added, caveating his words by saying “that’s not a forecast, that’s a concern.”

If and when people do get burned, there could be widespread “contagion” in the markets, bond market guru, Allianz chief economic advisor, and former co-CEO of PIMCO Mohamed El-Erian warned at a Bank of England conference in September.

“Risk has become embedded into the system as to the proliferation of instruments that look extremely attractive, because they are very cheap — ETFs — but are overpromising liquidity in inherently illiquid asset classes,” he said at the event, which celebrated 20 years of independence for the BoE.

“It is a huge risk of contagion. People are forced to do things they don’t want to do, and the next thing you know the real economy is at risk.”

“I suspect the next crisis will be from the non-banks,” he added, alluding to products such as ETFs.

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