Exchange traded funds, or ETFs, are one of the most successful financial innovations in the modern era; of similar vintage and, arguably, significance to mortgage-backed securities, but to date thankfully not (yet) as controversial. This article looks at their key features, contextualises their inexorable rise by reference to some performance figures and, by reference to two examples of their higher risk synthetic variants, leveraged and inverse ETFs, highlights both the potential systemic risks they pose to the stability of global financial markets and regulators’ preparedness to address those risks.

KEY POINTS

The rise of exchange traded funds (ETFs) is both meteoric and relentless. In the US, in 2017, there were US$40bn assets under management (AUM). By the end of the first half of this year, there were US$6.5trn AUM with inflows for the first six months of 2021 of US$473bn. In Europe, the story is similar; there are 9,737 listings and €1.2trn AUM with net inflows in the year to August 2021 of €87bn. –

There are two principal types of ETF, physical and synthetic. Synthetic ETFs, such as the leveraged and inverse variants, pose the greatest risk to investors, particularly retail investors in the US, where retail investors are not protected by regulation. –

While selling to retail investors in the UK, and Europe is now restricted, the greater risk posed by these products is to the financial stability of both the primary and secondary markets. If authorised participants (APs), particularly in the highly concentrated high yield exchange traded products (ETP) segment, are not able to absorb shocks without triggering net redemptions, there could be significant market instability. –

While this issue continues to be met with intransigence in the US, the UK, and Europe are beginning to assess these highly concentrated markets for resilience. But to date, only the fixed income ETF segment has been analysed. More work is needed and more urgently, particularly in relation to synthetic ETFs, where collateral tends to be illiquid, if a financial crisis, potentially in the order of magnitude experienced in 2008, is to be avoided.

INTRODUCTION

In essence, exchange traded funds (ETFs) are specialised index funds listed on national stock exchanges. The very first ETFs – stock or equities ETFs – were traded in Japan in 1968. They were first traded in the US, in 1976, and in Europe, first in the Netherlands, in 1987. They finally arrived in the UK, in the late 1990s. Since then, they have developed considerably and are now used in debt securities (ETNs), bonds (fixed income ETFs) commodities (ETCs), currencies, options and industries.

At its simplest, an ETF is a type of security that attempts to track or achieve the same return as a particular market index, such as the S&P 500 Composite Stock Price Index, the Russel 200 Index and the FTSE 100 Index, or a particular sector, commodity, or other asset. It can be purchased or sold on a stock exchange in the same way regular stock can, and, it can be structured to track anything from the price of an individual commodity to a large and diverse basket of securities or specific investment strategies.

In the case of a physical stock ETF, (see February edition (2016) 2 JIBFL 93 ‘The hidden structural risks in Exchange-Traded Funds’) the ETF buys the shares of the companies listed on the relevant index. Shares in the ETF are then created (or redeemed) in primary markets by authorised participants (APs) and are then exchanged between investors on the secondary market. The ETF provides investors, in the secondary market, with the opportunity to invest indirectly in each of the companies comprising a particular index without having actually to invest in their securities. Instead, by buying a single share of an ETF, the investor gains exposure to the whole basket of securities that the ETF holds, which often is numbered in the thousands.

For the most part, ETF managers do not have to decide how much of the underlying securities to buy. This is because many stock indices use market capitalisation to weight the securities. In the result, those companies whose shares have a higher market capitalisation or total value are more strongly represented in the relevant index. This means, that ETF managers need only match the securities’ weightings in the fund with the weightings in the corresponding index the fund is seeking to track.

So, by way of illustration, if a company A’s securities represent 2% of all the securities included in that index, the ETF tracking that index will invest 2% of the fund’s total assets under management in the securities of company A.

Although ETFs can be actively managed – with the manager deciding what will be included in the basket of underlying assets to be tracked – most ETF managers do not actively pick the underlying but, instead buy only those underlying assets – eg securities measured by a particular index. Most ETFs are therefore passively managed investments. This greatly reduces the cost of management services that, in an era of historically low interest rates and relentlessly rising equity markets, often generate little if anything in terms of outperformance. There are also other benefits of ETFs. They can be more tax efficient than owning other types of investment, such as mutual funds or packaged products, as ETFs tend to have lower capital gains distributions. ETFs also tend to offer greater diversification, balancing risk and reward, through investing in multiple holdings, often in the thousands. Whereas actively managed funds typically invest in far fewer.

An active ETF, on the other hand, offers a certain degree of freedom to the portfolio manager, who can move away from the composition of the underlying stock market index in order to improve its performance and reduce risks.

Among these passive and active physical ETFs, there also exists synthetic ETFs, as explained in ‘The hidden structural risks in Exchange-Traded Funds’ (2016) 2 JIBFL 93, February edition. Instead of buying each of the components of the stock market index directly, synthetic ETF managers use swaps and other derivative financial products to replicate the performance of the index. Physical ETFs offer the advantage of replicating the performance of the underlying index with great precision, but they are generally accompanied by greater costs. Conversely, synthetic ETFs have more attractive fees, but their performance may turn out to be uneven, especially since certain counterparties may be lacking in comparison with financial derivatives.

THE SUCCESS STORY

US-listed ETFs are on track this year to set yet another record for inflows. In the first six months of 2021, the ETF industry in the US, attracted net inflows of US$473bn. Whereas, ETFs drew a little above US$500bn in total in new cash from investors in 2020, which far exceeded the previous record set in 2017 of US$40bn. The ETF industry in the US, now has in total US$6.5trn of assets under management.

To put those figures into perspective, ETFs accounted for only approximately US$400 of assets under management (AUM) in 2005.

The increasing demand this year in the US, results from greater demand for stock ETFs. Whereas demand in the US, last year was fuelled by greater demand for fixed income and commodities ETFs.

In the first half of this year, stock ETFs acquired $363bn in net new money, surpassing 2020s total inflows by more than $100bn. Fixed-income ETFs added another $106bn in the first six months of the year, approximately in line with inflows of $206bn in 2020.

Similarly, the story in Europe has been equally meteoric. The European ETF market has also seen record inflows this year. There remains strong demand for equity with inflows in Q1 of €48.2bn taking AUM to €1.2trn. That is an increase of 10% from the end of the previous quarter. Stock ETFs listed in Europe reported net inflows exceeding €6bn during August, bringing net inflows for the year 2021 to more than €87bn. This is in stark contrast to the €10bn net inflows stock ETFs attracted in the year to date in 2020.

At the end of August this year, the European exchange-traded products industry had 2,499 products, with 9,737 listings, assets of $1.543trn, from 85 providers listed on 29 exchanges in 24 countries. These figures reveal a significant turnaround in fortune since 2012 when demand for physical and synthetic ETFs was depressed. In fact, in 2012 more than 75% of synthetic European ETFs were at risk of closure for failure to meet the minimum inflow of US$30m required to ensure long-term viability. Since then, adoption rates in the EU for both physical and synthetic ETFs has followed ETF investment patterns in the US.

These results are all the more impressive given that worldwide 297 ETFs, representing 5.5% of ETFs, were wound-up during 2020. This is compared with closure rates of 4.3% in 2019 and 3.5% in 2018.

The growth of ETFs in more recent times is in large part a symptom of the general disillusionment felt for active management. It may be characterised as representing a triumph of low-cost passive management over high-cost active management in which funds simply try to match performance of the market instead of trying to better it, which history shows very few active managers have been able consistently to achieve. But that is to grossly oversimplify ETFs.

INNOVATION

Fundamental to their success is the structure of the funds themselves which is far more sophisticated and varied than the above explanation suggests. ETFs have great potential beyond simply index tracking.

As explained in ‘The hidden structural risks in Exchange-Traded Funds’ (2016) 2 JIBFL 93, February edition, synthetic ETFs are such an innovation. Two variants of the synthetic EFT are leveraged ETFs and inverse ETFs. Those are complex high-risk instruments.

Leveraged ETFs

A leveraged ETF, also known as a bull or bear fund, is a marketable security (in the US) and transferrable security (in Europe and the UK). It uses a combination of financial derivatives and debt to amplify the return of underlying indices. Those indices are largely restricted to mainstream equity, commodities and currency pairs.

While a traditional physical ETF typically provides the daily return of an underlying index on a one-to-one basis, a leveraged ETF aims to achieve twice or even three or four times the daily return of the relevant index.

For example, a leveraged ETF that tracks the S&P might use options and debt to magnify each 1% gain in the S&P to a 2% or perhaps even a 3% gain.

The use of options contracts enables an investor, for a premium, to trade any underlying asset – in this case a security – without the obligation that they must buy or sell the security. The extent of the gain obtained is contingent upon the amount of leverage used in the ETF. Leveraging is an investment strategy using borrowed (or margined) funds to buy options and futures to increase the impact of price movements.

Leverage, however, can work in the opposite direction as well, leading to significant losses. So, for example, if the underlying index were to fall by 1% the loss magnified by the leverage would be 2 or 3% greater.

Leveraged ETFs, although costly, with expense ratios not uncommonly of 1% or more, tend to be less expensive than trading on margin where fees can be 3% or more on the amount borrowed. This type of synthetic ETF is typically used by traders and experienced investors who understand the risk inherent in using leverage who wish to speculate on an index, or to take advantage of the index’s perceived short-term momentum. Because of their high cost, high risk structure and also because the derivative instruments used to create the leverage are themselves short dated, they are invariably held for up to a few days only; they are used rarely as long-term investments.

Inverse ETFs

These also use derivative instruments – such as daily futures contracts – but to profit from a decline in the value of an underlying index or benchmark such as the Russell 2000 or the Nasdaq 100 or as a hedging tool against falling prices for example in the S&P500.

Broadly, if the market falls, the inverse ETF rises by roughly the same percentage minus fees and commissions, which can have management expense ratios of up to around 2%. Investing in inverse ETFs is analogous to holding short positions, which involves selling borrowed securities with the hope of repurchasing them at a lower price hence this variant of ETF is also known as the “Short ETF” or “Bear ETF”.

There are several variants of inverse ETFs including those which focus on specific sectors such as financials, energy and consumer staples.

A leveraged inverse ETF is conceptually the same as a leveraged ETF but aims to deliver a magnified return – typically boosting returns to 2:1 or 3:1 – when the relevant market is falling.

Advantages of inverse ETFs is that they do not require the investor to hold a margin account which is required if entering into short positions. Nor do they give rise to stock loan fees. So, despite higher expense ratios for this type of ETF than for non-leveraged ETFs, costs are less than those ordinarily incurred when selling stocks short.

Inverse ETFs, though intended for professional investors, can be bought by anyone with a brokerage account including potentially retail investors. They are highly sophisticated short-term trading instruments that carry the very real and significant risk of substantial losses if entry and exit timings are not perfectly judged. In that sense, these instruments involve an element of gambling that increases in order of magnitude to the investor’s level of inexperience.

The risk of loss is more acute in periods of market volatility because of the requirement for these products to be rebalanced daily, meaning that the underlying must be bought and sold to ensure the ETF replicates the corresponding index.

SIGNS OF TROUBLE, OR HAS THE WRITING BEEN ON THE WALL NOW FOR SOME TIME?

Over the past decade or so, US investors and regulators alike have litigated complaints that there has been insufficient information disclosed about how these products perform and are managed.

Concerns were first raised in 2009 when US regulators warned investors that some synthetic ETFs, particularly leveraged and inverse variants, were failing to deliver the multiples or the inverse of the indices they aimed to track. This left many investors, particularly retail investors, with significant losses which in turn led to fines – eg issued by FINRA (Financial Industry Regulatory Authority) to Wells Fargo.

In May 2012 the SEC fined Wells Fargo, Citigroup, Morgan Stanley, UBS and associated brokerages as well as RBC Capital Markets more than US$12m for marketing leveraged ETFs inappropriately without proper due diligence and, in the case of RBC, without proper training. Those fines were followed by two class actions against ProShares and Direxion for mis-selling. The former was dismissed whereas the latter settled. Wells Fargo was fined again in 2020, this time US$35m, for selling complex ETFs that were unsuitable to retirement savers who bought them.

In addition to concern for investors, Regulators in the US and in the EU are equally concerned that banks, particularly in the EU, may be using ETFs as a cheap source of funding and are filling them with less liquid collateral – such as high yield corporate bonds – taking those securities off balance sheet, where they would otherwise have been subject to high capital charges. The concern here is that that could create liquidity risk if ETF investors in sufficient numbers seek at once to exit their positions.

Despite having had more than ten years to consider the impact of these investments on both investors and markets alike, to date, US regulators’ hands have been tied as a result of political intransigence and investor pressure. Their proposals to restrict sales to the retail investors has met with stiff resistance from the investor community, notwithstanding their losses, forcing the proposals to be shelved if not abandoned.

Whereas their published concerns, that leveraged ETFs could have a destabilising effect on financial markets, particularly in periods of stress when asset prices are falling, have to date largely been ignored.

In the UK however, the FCA has imposed restrictions on firms marketing, distributing and selling these products to retail investors (see COBS 22). Those restrictions were introduced earlier this year. So, that regulatory gap has been plugged.

The FCA, however, has not yet fully addressed the systemic risk these investments pose to the primary and secondary markets, particularly the synthetic variants. ETFs have a dual existence in the markets. Broadly, their shares are created and redeemed in the primary market by APs, broker dealers and institutional investors. Whereas ETF shares are bought and sold in the secondary market by individual investors including retail investors.

Research undertaken for the FCA in August 2019 and in January this year concentrates on fixed income ETFs in both the primary and secondary markets in Europe. But, none of the other variants, particularly synthetic ETFs, have yet been examined in any detail.

Those two FCA-commissioned studies conclude, worryingly, that resilience is of particular concern for ETFs with less liquid underlying assets, which are potentially less able to absorb shocks without triggering redemptions.

This should be of concern, given that the ETF primary markets are highly concentrated, particularly so for fixed income ETFs. Most European ETFs are split between investment and wholesale banks and principal trading firms with five of the most active APs responsible for about 75% of the overall reported primary market volumes (across all asset classes). Concentration is apparently particularly pronounced in the fixed income market, with the top five APs accounting for 91% of overall volumes and the top AP itself accounting for 51%.

The story is strikingly similar in the secondary market, with institutional investors having around a 98% share of the trading volume of which APs account for 80%. Also, the top five APs account for approximately 60% of volumes in fixed income ETF and 45% in equity ETFs.

Therefore, in times of stress, that degree of concentration could prove significant in the context of the availability of liquidity and resilience in both the primary and secondary markets. It remains to be seen whether in periods of stress APs would be willing and able to participate, if for any reason, investors were engaged in heavy selling.

In that regard, the research commissioned by the FCA identifies three potential stress periods against which APs’ behaviour in the primary market was measured so to better understand how they might behave in periods of high volatility. The stress periods chosen were the US Presidential Election in November 2016 (on which the study focussed because it exerted the greatest stress on the primary market), a volatility spike in 2018, and a fixed income sell off in December 2018, ahead of the mid-monthly volatility spike.

In those periods, APs’ behaviour was observed to have changed. The combined market share of the three most active APs declined from around 95% to around 85%, suggesting a retreat and that other previously less active APs stepped into the market and absorbed proportionately higher redemption volumes. In other words, the lower activity APs acted as alternative liquidity providers when the previously more active APs took a step back. But, to rely on the less active APs to provide market stability would be foolhardy to say the least particularly given that the study points out, it did not analyse the reasons for why less active APs stepped in. So, any confidence that they would step-in again would be entirely misplaced. Nor did the study compare and contrast regulatory data from primary markets and underlying assets.

In relation to the secondary market, the second of the two studies concludes that in periods of volatility APs in the non-high yield segment acted as a buffer between the two markets with levels of non-high yield redemptions in the primary market below the levels of buy volumes in the secondary markets. However, the very real risk remains that, because of the overall size of the ETF market, because of the illiquid nature of collateral held within high yield synthetic ETFs, which could well be far less resilient than assumed, and because the ETF markets are so highly concentrated, in periods of high volatility significant financial instability potentially in the order of magnitude seen in 2008 could be higher than presently understood.

Anthony Dearing - December 2021 Butterworths Journal of International Banking and Financial Law