ETF risks: Exchange traded funds far from risk-free – The Australian Financial Review

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It is estimated that globally about $5 trillion is invested in ETFs, about 70 per cent of which is in the US.

by Elio D’Amato

There has been an extraordinary rise in the number of exchange traded funds (ETFs) available to the Australian investor over the past 10 years and their influence on the Australian market has been growing.

According to the ASX the amount of money invested in ETFs is estimated at $25 billion, a 15-fold increase from 10 years ago. ETFs in Australia account for, on average, about 1 per cent of all daily trades.

However, the same report estimates that globally some $5 trillion is invested in ETFs, about 70 per cent of which is in the US where ETFs account for one-third, or $100 billion of trades every day. Still, given the growth rate domestically, it would be a folly to suggest that the trend in ETF investing in Australia will not continue, both in size and array of investment options. 

The rise of ETFs has been driven in part by a growing belief that “asset allocation” rather than “asset selection” is the key to achieving long-term investing success.

Companies such as Vanguard, State Street and Barclays have successfully highlighted the benefits of passive investing versus investing via an active manager, who may have a mixed history of beating the market. This has fuelled an often-incorrect assertion that ETFs are lower risk than funds that proactively manage portfolios and focus on investing in great businesses. 

It is important to note that all investments carry risks, even cash. ETFs are no exception. Many of the risks for ETFs are articulated in an informative education series on the ASX website where issues such as different ETF structures, market, currency and tracking-error risk are all well documented. 

With their popularity and influence on the market rising both domestically and overseas, one needs to interrogate other risks ETFs pose to ETF investors and the broader market. The following are structural risks that stand to impact investors significantly, should they eventuate.

1. The next ‘big’ correction

What will be the role and influence of ETFs in a severe and rapid market correction? While the global financial crisis was only 10 years ago, the size and influence of the global ETF market was not as big as it is today.

Domestically, the largest ETFs tend to be share index funds, or those based on indices such as the S&P/ASX200. And while the ASX200 still only has 200 companies in it, the amount of money that has gone into these ETFs has blown out significantly. Therefore, with all the money corralled into the same number of stocks, what will happen when the market turns on itself? More importantly, how will ETFs contribute to the panic and sell off?  

2. Run on frozen funds

When an investor sells their ETF unit on the market, they are effectively telling the ETF provider to sell down some of their holding to meet a commitment. While another investor may buy it from them, the ETF provider is also required to be the market maker and a counterparty to the transaction at a price relative to the fund’s net asset value (NAV).

But how will an ETF provider act should a swift and aggressive market correction occur? As the ASX reminds us, ETF providers are under no obligation to make the market at all times. Therefore, where there is extreme stress and volatility, funds could be frozen by ETF providers. This risk is heightened for ETFs that invest in less liquid assets. 

3. Inefficient pricing 

On May 6, 2010 the Dow Jones suffered a 1000 point (or 9 per cent) drop in 20 minutes as 2 billion trades were executed.

According to the Securities and Exchange Commission, 200,000 trades across 300 securities were executed at prices 60 per cent lower than they were moments earlier. The regulators subsequently reversed many of these trades. ETFs accounted for a disproportionate 68 per cent of these trades. 

Then on August 24, 2015, with 471 different ETFs and stocks in a circuit-breaker lock down and with only half of the S&P500 traded at the opening, the pricing mechanism for many ETFs simply broke within the first 15 minutes of trade. In both scenarios the market eventually returned to normal. However, these risks remain, particularly as funds under administration in ETFs continue to grow. 

The aim of this article is not to demonise the ETF industry, nor is it to discredit their use within a well-diversified long-term portfolio. However, what it does intend to do is remind investors that though the investment strategy regarding ETFs is passive, there is no reason to be lazy about understanding the structural risks on all their investments. Especially when there is a vast range of quality education available for investors. 

Sometimes, holding on to great businesses and making your own decisions can be a simpler process to stomach.

Elio D’Amato is director of research and education at Lincoln Indicators. incolnindicators.com.au

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