Like any good gardener, the US financial regulator has decided that the rapidly expanding exchange traded fund market may need pruning to ensure healthy growth.
Just a couple of months before the ETF market had set a new record for global asset gathering — some $372bn for 2015 as a whole — Luis Aguilar, commissioner of the Securities and Exchange Commission, was asking: “Should we consider curtailing the growth of ETFs?”
His question was posed during a speech in October to fellow regulators in Washington after more than a fifth of all US-listed exchange traded funds were forced to stop trading on August 24. That morning the Dow Jones Industrial Average had dropped nearly 1,100 points in the first few minutes of trading before rebounding by almost 600 points just moments later.
Trading on that day was the most volatile in the US for four years, and was littered with more than 1,000 trading halts — stoppages that inhibited the essential arbitrage mechanism of ETFs and prompted their prices to fall well below the indices they are designed to track.
The wild price swings prompted Mr Aguilar to pose seven questions about the credibility and suitability of ETFs at the October meeting. These included whether the time was now right to “re-examine the entire ETF ecosystem” and culminated in him asking whether the ETF market had grown too big.
Mary Jo White, chairwoman of the SEC, added that the commission was paying “close attention” to the problems.
For many, Mr Aguilar’s main question is easily answered. Yes, they say, the ETF market should be trimmed and the sooner the better.
Investor John “Jack” Bogle, who founded low-cost fund giant Vanguard and created the first ever index fund, says: “Yes, it is high time both the ETF industry and policymakers re-examine the entire ETF ecosystem. Why? Because of its sheer size and fragility in times of market stress.”
Mr Bogle is a long-time critic of the market who has previously told investors to “beware” of ETFs, warning that the only clear winners in the rapidly expanding market are the brokers and dealers.
He told FTfm last year: “Mark me as a member of a small group of cohorts who are dubious about the utility of ETFs for long-term investors.”
What is an ETF?
At their core, ETFs combine the key features of traditional mutual funds with those of individual stocks. Like index funds, ETFs represent diversified portfolios of securities that track specific indices and, like stocks, they can be bought and sold on an exchange throughout the trading day.
ETFs have been championed for being a simple investment structure and, when the first one was launched in Canada in 1989, the story was that they were low cost, transparent and uncomplicated.
Today, that picture looks somewhat different, with ETFs now under attack for being complex and opaque.
Adam Laird, head of passive investment at Hargreaves Lansdown, the fund supermarket, says: “ETFs are an area of growing concern for regulators. This stretches beyond the SEC to European regulators as well, because the growth of ETFs is changing behaviour in markets.”
In December alone, ETFs posted net inflows of $55bn, marking the 23rd consecutive month of positive net flows, according to research firm ETFGI. Total assets, meanwhile, stand at $2.99tn — a figure consultancy PwC expects to hit $5tn by 2020.
“The growth is scary,” says a senior executive at a European ETF provider, who wishes to remain anonymous. “If I was a regulator I would be having a look at that too.”
Nigel Brashaw, lead author on PwC’s report, “ETF 2020: Preparing for a new horizon”, adds: “Since their introduction only two decades ago ETFs have been undeniably successful, growing far beyond their initial function of tracking large liquid indices in developed markets.”
That change of direction is what worries critics. ETFs were championed for being a simple investment structure and, when the first one was launched in Canada in 1989, the story was that they were low cost, transparent and uncomplicated. Today, that picture looks somewhat different, with ETFs now under attack for being complex and opaque.
Many feel the ETF brand is being tarnished by a flurry of poorly manufactured ETFs coming to the market. One section of funds to face particular scrutiny is leveraged and inverse ETFs, a set of funds that Larry Fink, the chief executive of BlackRock, the world’s largest fund manager, simply calls “toxic”.
Leveraged ETFs seek to deliver multiples of the performance of the index or benchmark they track, while inverse ETFs aim to return the opposite performance of the benchmark they follow.
Mr Bogle is highly critical of the launch of funds that differ markedly to the original ETF structure. In his editorial for FTfm published last year, he wrote: “In my experience — almost 64 years in the fund industry — I have learnt to beware of investment ‘products’, especially when they are ‘new’ and even more when they are ‘hot’. Avoiding hot new products is unlikely to impair the returns investors earn. Far more likely the reverse is true.”
He adds: “I believe that too few investors fully understand the appropriate uses of ETFs.”
Peter Sleep, senior portfolio manager at 7IM, the UK wealth manager, is sympathetic to Mr Bogle’s concerns up to a point. He says: “It is only natural for commentators to question and want to kick the tyres of something that is as new and popular as ETFs.”
However, Mr Sleep believes many of the fears are overstated: “I have just finished reading a book on the early days of the railway boom. Railways faced similar scrutiny with commentators worried that trains would stop hens from laying, cause cows to stop grazing and cause people to atomise from travelling at the breakneck speed of 12.5mph.”
A sense of calm is needed, he says. Nevertheless, doubts about the safety and suitability of exchange traded funds continue to surface.
Those worries first appeared after the “flash crash” in May 2010 when US financial markets experienced a brief but severe drop in prices. ETFs were initially blamed for causing that crash but investigations by US regulators eventually blamed a poorly executed $4.1bn derivatives trade.
More recent dissent has come from Carl Icahn, the billionaire activist investor, who became involved in an extraordinary argument with BlackRock’s chief executive while sitting next to Mr Fink at a conference in July last year. Mr Icahn claimed high-yield bond ETFs could create severe liquidity problems and described BlackRock, which notched up a record $139bn of ETF inflows last year, as “an extremely dangerous company”. Mr Fink dismissed the criticisms as “flat-out wrong”.
Meanwhile, the Financial Stability Board, which was set up after the 2008 financial crisis and represents central banks and regulators, said in 2011 that it had seen “a number of disquieting developments” in the sector.
At the same time, the Bank of England warned that the risks associated with ETFs were not being made clear to investors.
Mr Laird reiterates that many of the concerns are overblown and, in reference to the problems seen in August, says: “In my view, the problem is not with ETFs but short-term trading disrupting markets.
“ETFs are one tool for speculators, but we must not throw the baby out with the bathwater — many investors use ETFs in long-term buy-and-hold portfolios.”
The senior executive at a European ETF provider, revisits the gardening analogy: “There is no doubt the ETF market is getting a far harder time than it deserves but I must admit it’s getting a little wild and could do with some cutting back.”