Passive Investing – ETFs are a lot riskier than first thought

It is estimated that $36.2 billion is invested in Exchange Traded Funds (ETFs) locally, representing 1% of exchange transactions. However, this is only a fraction of the $5 trillion global ETF market which is forecast to grow out to US$20 trillion by 2020. The passive investment space is predicted by some to exceed the actively managed fund market by 2027. The Australian market has experienced a 20-fold increase in the last 10 years while experiencing a 33% increase in 2017 alone. Therefore, it is inevitable that the ETF market will continue to grow dramatically, both in size and array of investment options, with coming at the expense of investments into high-return actively managed funds like the PEF Long Short Equities Derivative Fund.

Since the S&P500 Depository Receipt fund, nicknamed ‘Spider’ was launched in 1993 on the American Stock Exchange (now the NYSE MKT LCC), the popularity of ETFs has been driven by the belief that success in long-term investing comes down to asset allocation rather than asset selection. Reflecting this, US$2 trillion has been moved out of active funds into index funds and ETFs globally over the past 15 years. While some consider ETFs to be lower risk than actively managed funds, the reality is that ETFs could carry significantly more ‘latent’ risk — while ETFs have been able to thrive during expansion of the market, they have not been tested in a significant market downturn.

Why do ETFs carry greater market risk than actively managed funds?

A fundamental character of ETFs is that they are structured to mirror the underlying index (with some boutique ‘smart-beta’ funds tilting their asset weightings occasionally. The ETF landscape has grown significantly since the last global financial crisis 10 years ago. It is anticipated that the ETF market at its current size will react more severely than many listed securities markets did during the global financial crisis if it were to experience similar hardships now. Experts believe that the next financial crisis will be from non-banks financial entities, suggesting that products such as ETFs will be unable to cope with a substantial market correction.

As the largest ETFs domestically tend to be composed stocks from the ASX200, this has disproportionally increased the market capitalisation of these already-large stocks. We see ETFs distorting the market by drawing investors to large cap stocks simply to comply with index-fund weightings while ignoring other market fundamentals such as price to earnings or return on equity. This would create a high level of uncertainty amidst a market downturn where there is an excess of investors relying on the performance of Australia’s largest companies which have the greatest exposure to declining economic conditions.

While we see the attractive performance offered by ETFs in strong market conditions, investors ought to be aware that these strong returns may come from leveraged ETFs, utilising debt and derivatives to magnify returns at the expense of a high level of risk. These types of ETFs would likely be the first effected by a downturn which is likely to be on the horizon if US rates start to rise. In February 2018, Credit Suisse announced it would wrap up its ETN-XIV volatility ETF after its value fell more than 90% in one day. The once-$2.2 billion fund was seen as an easy trade attracting passive-investor funds until market volatility rose 115% on 5 February 2018, decimating the VelocityShares Daily Inverse VIX Short-Term ETN (XIV) and ProShares Short VIX Short Term Futures exchange-traded fund (SVXY).

It is feared that the ETF market has been subject to a bubble effect where large sums of capital is poured into these investments in response to their seemingly attractive returns. The risk behind this lies in the fact that the prices of the underlying stocks are being pushed to unsustainable prices by investors who negate to consider whether the actual constituents are over-valued and are simply drawn to the ETF on face value based on its past performance.

How liquid are your ETF assets during a downturn?

ETFs may seem to save investors high active manager fees, but this comes at a much higher cost — inherent liquidity risk. While there will always be a market for the large cap stocks, the investors who will get burnt the most are those who invest in ETFs consisting of investments which are inherently harder to sell in certain circumstances. As ETF providers are under no obligation to make the market under situations of extreme stress and volatility, the worst-case scenario is that funds are frozen within an ETF by the providers. This highlights the importance of looking into the constituents of the ETF and determining whether there is an active market for those particular asset classes.

Do ETFs experience other types of risk?

In addition to market and liquidity risks, ETFs can be subject to other forms of risk such as tracking error where the returns deviate from the index or benchmark tracked (despite this being a fundamental reason for investors choosing to invest in ETFs). ETFs can also be exposed to exchange rate fluctuations, derivative and counterparty risks in addition to having potentially adverse taxation outcomes for investors. Combined, all of these can outweigh the small management fee savings many passive investors place paramount importance on.

Key Takeaways – is there a solution?

While there are certain advantages that ETFs offer, such as lower fees, compared with actively managed funds, it is essential that investors are aware of the constituents of the ETFs they choose to invest in. Furthermore, investors should primarily be aware that although ETFs have generated strong returns in recent times, their ability to withstand adverse market conditions remains unknown and could well suffer much greater risk of loss from market events compared with many actively managed funds.

The PEF Long Short Equities Derivative Fund offers an effective hedge against the market risk of ETFs. If you are considering investing in an actively-managed fund which outperforms the Australian ASX200 index, get in touch with us at info@www.pefcapital.com.au.

4 September, 2018 in Investment insights

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