Could a market correction turn ETFs into WTFs?

By Lucy Dean

January 18 2018
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ETFs have grown 500 per cent in value since 2008 but the innovation in asset management is “yet to be tested in crisis conditions”, so how would it cope in a correction?

As such, the question is whether a market correction would see ETFs “cushion the blow” or exacerbate the negative impacts, the World Economic Forum (WEF) said in its Global Risks Report 2018, released this week.

The Forum explained: “The world is eight years into a bull run, with global stock markets hitting all-time high after all-time high.

“This has raised fears that this is another episode of “irrational exuberance”, that the lessons of the crisis have gone unlearned, and that a deep correction may follow.”

An ETF, or exchange-traded fund, is an investment fund that is traded on a stock exchange and will typically track an asset or market index.

The WEF noted that the Dow Jones increased by 25 per cent in 2017, while the S&P grew 19 per cent, the DAX by 11 per cent, the Hang Seng in Hong Kong by 35 per cent and the Nikkei in Japan by 19 per cent, and said in terms of cyclically adjusted prices, US stocks have only been higher than they currently are twice in history, in 1929 and 2000. Those years mark periods “just prior” to market crashes.

Similarly, bond valuations are “even more dramatic”, the WEF said.

“In mid-2017, around 9 trillion US dollars’ worth of bonds were trading with a negative yield, meaning that investors were, in effect, paying bond issuers for the privilege of holding their risky financial instruments.

“This anomaly reflects the impact of the huge asset-purchase programmes launched by central banks in the wake of the crisis, which seem to have divorced asset prices from assessments of their underlying riskiness.”

However, together with surging property prices and cryptocurrency values, ETFs were listed as another potential risk.

The WEF claimed: “A further source of potential market risk at present is that innovations in financial assets and asset management have yet to be tested in crisis conditions.

“One example is the rapidly expanding class of ETFs, which have grown in value by 500 per cent since 2008 and now account for US$4 trillion of assets and around 25 per cent of all US stock market trading.

“Some analysts suggest that ETFs would cushion the blow of a major market correction, while others reckon they would exacerbate it.”

Deutsche Bank in September last year called the growth in ETFs value “extraordinary” and questioned whether the vehicle would be a “help or hindrance to markets going forward”.

Strategists Jim Reid, Craig Nicol, Nick Burns and Sukanto Chanda said: “Low costs, tax efficiency, low volatility, transparency of pricing and holdings, liquidity and of course the eight to nine-year bull market for risk assets in particular are all reasons which have helped fuel demand for these products.

“As the market has grown so has the investor base with the products appealing to both retail and institutional money.”

The strategists said that as ETFs are passive, index-tracking funds, they “naturally” favour large caps and that as such, this theoretically means the “biggest companies are getting bigger, regardless of fundamentals”.

“The concern therefore being that these companies are perhaps more susceptible to overvaluation and the gap between the small/mid to large caps also widening. This could potentially mean that risks are amplified when you see a big market correction, which arguably ETFs haven’t yet been tested with yet.”

Acknowledging that ETFs were testing following the collapse in oil prices in early 2016, the strategists said there were two main ways the vehicle’s reaction could be assessed.

“[When prices fell] trading volumes for the BlackRock iShares HYG and State Street JNK funds – the two biggest high yield ETFs – hit the highest on record,” the strategists began.

“One camp argued that the ETFs achieved one of their purposes in acting as a source of liquidity for the market. However the other camp argued that the managers of these ETFs were forced to sell underlying bonds into an illiquid market, compounding the selloff.”

However, Mr Reid and co. argued that ETFs have “not yet been fully tested in a sustained bear market”.

“The real test could be when we see the next downturn and these products are faced with heavy redemptions. This will be particularly paramount for less liquid asset classes,” they continued, arguing that the growth in more “exotic niche” ETFs further complicates the landscape.

Concluding, the strategists said ETFs demand scrutiny, “particularly in the context of their surge in popularity for retail investors and as with any market still somewhat in its infancy, the real test is probably still to come”.

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