Helen Thomas founder of BlondeMoney, a macroeconomic consultancy launched in 2017, outlined her concerns in an interview published on its website conducted by Liquiditv, a digital platform for alternative funds.
She said: “The reality is that ETFs contain a design flaw. The tracking process comes about because market makers arbitrage away differences in price, between the underlying asset and the ETF. If they deviate, there should be a risk-free return because they’re the same thing, right? But, arbitrage only works when there is liquidity. And the liquidity in an ETF is dependent on the market makers and their creation agents, the Authorised Participants. They aren’t obligated to make a price, and if it’s too hard to get hold of, say, a high yield bond, then they step away from pricing.
“It’s nothing to do with Blackrock or Vanguard; they’re just the shop front. If you go in to buy some chewing gum, it won’t be there if the suppliers stop delivering.”
Thomas is also concerned that the ETF market is now of a similar size to the credit default options market before the last financial crisis and that the ETF market is just “too unwieldy”.
She says the hedging process involved with ETFs leads to flows that dominate the market. A complex system can see much risk relatively easily hedged, but some actually use ETFs to hedge part of the ETF risk. Trading desks of banks and brokers can, instead of hedging also take some risk as proprietary risk.
“Banks are taking on hidden leverage on the back of ETF flows and their capital charge is lower if the risk sits on the Delta One desk, because those positions are for ‘market making purposes’,” she says. “Hidden leverage and unpredictable liquidity are the hallmarks of every financial crisis we have ever seen.”
She worries that ETFs depend on functional liquid markets. “The virtuous circle where quantitative easing drove money into passive investments which compressed credit spreads, lowered volatility, and led money back into risky assets – that’s about to turn into a vicious one.”
But if that is the warning from a City professional who has, among other things, worked for global investment banks, a hedge fund and advised George Osborne during the last financial crisis, what does the retail market make of such concerns?
Peter Lowman, chief investment officer at Investment Quorum, says: “Basically, over the last decade the ETF market has grown enormously, which in any asset class, could be seen as a bubble, and therefore, opens the possibility of being a crowded trade and that could create a financial risk, or crisis, if we were to experience a meaningful sell-off, given that ETFs can be sold effectively and very quickly by investors.”
Wellian Investment Solutions chief investment officer Richard Philbin says: “There is a lot of truth to what she says, and I feel the advancing of the derivatives markets, backed by QE have helped create the perfect storm of which ETFs can find themselves sitting in the middle.”
Philbin says QE has basically given free money out and ETFs trading at a couple of basis points have provided market participants wanting to access the stock market a quick, cheap way of doing so.
“It also provided liquidity,” he adds. “Equity markets are driven by supply and demand as well as fundamentals. There are many companies who will have benefited from capital due to index buying even though fundamentally the company itself isn’t worth the price the ticker says it is.
“Arguably when central banks are pumping trillions into the economy, and most of it going to the financial economy rather than the broader economy, the demand for shares, partly driven through ETFs, is higher than the quality of the company.
“When the supply/demand goes the other way, because of the ‘liquidity’ available in ETFs, it is going to be these structures that are likely to see the first round of redemptions. Then, the market gets priced down, and the algorithms that are in place on many strategies get kicked off to sell and so the death spiral begins.
“What will happen when QE finishes – not just to the equity markets, but to the credit and sovereign debt markets? Passive activity is indiscriminate – there is no price discovery mechanism relating to the underlying equity. Remember that a company typically has a fixed number of shares in issue (unlike a passive instrument) which means the passive can continue to grow in market cap size, but the share of the company hits a bottleneck and extreme price movements can occur. The last couple of “fat finger flash crashes” are prime examples…”
Jason Hollands, managing director for business development at Tilney, says concerns around whether ETFs could cause systemic risk have been brewing for some time and this is certainly on the radar of many regulators across the globe.
“These principally centre round what might happen in stressed market conditions, where liquidity dries up and whether this could magnify and exacerbate market disruption rather than trigger it per se. That’s because ETF prices rely on market makers to limit the decoupling of their prices and the underlying baskets of securities they aim to replicate, so there is a counterparty risk. In a situation where an ETFs’ tracking error blew out, this could cause panic selling.”
How will they fare in a bear market?
So should individual advisers and investors be wary of the product?
Lowman says: “I think that there are certain individual ETFs that advisers and investors should be wary of given that after such a lengthy bull market many of the underlying constituents look expensive. Clearly, we are now in a period when it’s ‘what you own in the market’ rather than ‘owning the market’, however, saying that, there are some interesting thematic ETFs that are capturing the changing global landscape within our world today.
“While ETFs have been positively promoted as a cheaper solution to active managers, with supposedly better performances in these bull market years, the question now must be how will they do in a bear market period when active managers can hold cash, and be stock specific, and defend aggressively against a falling market?
“We have seen what ETFs can do in the bull market, but how will they do in the bear market?”