ETFs: Riskier than Advertised?

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For anyone who has been paying attention, it’s no surprise to learn that the exchange-traded fund industry has seen phenomenal growth, in the U.S. and elsewhere. According to data provider ETFGI, U.S. and global ETFs outstanding have increased by 970% and 740%, respectively, since 2005, while assets under management have jumped by more than 600%, to $2 trillion and $2.9 trillion, respectively, over the same span.

It’s not hard to see why ETFs have proved so popular. Among other things, this kind of structure affords investors considerable flexibility and control, allowing them to allocate funds to a particular sector, investment style, region or other category, and to do so whenever markets are open for business, unlike with mutual funds, which generally allow investors to acquire and redeem holdings once a day.

Another, more cynical explanation for the rapid pace of expansion likely stems from the fact that ETFs have given brokerage firms and fund sponsors a way to generate extra revenue from an approach that has gained in popularity in recent decades: passive investing. By definition, the aggressive marketing being done by financial firms indicates as much.

Unintended consequences

That said, the trend toward investing in ETFs (and similar vehicles) has created some unintended consequences. As noted in “Are Passive Investments as Risky as Hedge Funds?” the shift toward pooled investments, many of which are passively managed, does not necessarily mean that investors are in a better place as far as their portfolios are concerned.

In fact, it seems that they have swapped one set of risks for another. Arguably, the biggest stems from the ETF industry’s success. Among other things, investors don’t appear to be paying as much attention to risk exposure as they did when the emphasis was on individual securities. Even in those cases where underlying assets are being passively managed, there seems to be some sense that brokers or fund sponsors are looking out for investors.

But that is not necessarily the case. While it is likely that blatantly fraudulent investments will be excluded from an underlying pool, there are no guarantees. For those ETFs that mirror a particular index or sector benchmark, decisions about whether a security is included or not are effectively delegated to others, who may not share the perspectives of those who are seeking positive returns on their investments.

An array of risks

Worse still, investors may be taking on other risks that they are not aware of. In the case of a passively managed fund, an investment in, say, a certain sector may include well-managed and poorly run companies that happen to have something in common. Unlike with traditional security-level analysis, buyers of passively managed ETFs invariably end up throwing some good money after bad.

Indeed, there often seems to be little differentiation among the securities of companies in loosely similar industries, even though some may actually benefit at other’s expense because of their particular operating niche or area of expertise. In a low oil-price environment, for example, companies that have significant refinery operations or strong balance sheets would likely fare better than the broad universe of energy sector peers.

And because the underlying holdings are often weighted on the basis of capitalization, it is conceivable, maybe even likely, that investments which are overvalued for one reason or another will be further inflated as a result of being included in a popular fund vehicle. Instead of gaining risk-reducing diversification, investors may end up with funds that are heavily influenced by the fortunes of a few.

Not so liquid

The proliferation of ETFs targeting different niches has seen a widening array of exotic, illiquid, and risky instruments being bundled together, which can convey a false sense of security. For one thing, owning multiple securities in a thinly-traded segment may not provide the diversification benefit that some might expect. Moreover, many of the funds that promise more bang for the buck, such as the leveraged index ETFs, have inherent structural flaws and risk-magnifying characteristics that can cause serious damage to investment portfolios.

The fund industry’s expansion into all corners of the investing universe also means that certain ETFs may prove to be the only hedging vehicles that traders have available to them, heightening the risk of a one-way stampede–or even a “flash crash.” Reports suggest that some ETFs got hammered during the 2015 meltdown in high yield fixed-income markets because they were essentially in the wrong space at the wrong time.

Ironically, the boom in issuance has likely detracted from market liquidity rather than adding to it. The fact that growth has largely been concentrated in a relatively small number of ETFs obscures the reality that many aren’t sufficiently large or widely followed enough to ensure they can be readily traded under certain conditions.

According to the Financial Times, approximately 70% of the funds available to investors globally have less than $100 million in assets, while almost a third have less than $10 million. As with small cap stocks, smaller ETFs can be difficult to trade at acceptable prices because the number of competing buyers and sellers at any given point may not provide enough depth to facilitate trading, especially when, as detailed in “Market Liquidity: A Deteriorating Outlook,” conditions are already less than optimal.

Risky layers

Another issue with ETFs and other products that add layers between investors and underlying investments is that they can introduce a potentially destabilizing wrinkle: counterparty risk. As was the case during the global financial crisis, when many of those who believed they were protected by having certain collateral discovered–belatedly–that they were exposed to firms that were in serious trouble, current ETF owners may one day wake up to a similarly unpleasant surprise.

The key point, of course, is that while ETFs do, in fact, provide a number of advantages to investors, they are not without risks. As with hedge funds and other investments, the question always comes down to the trade-off between risk and reward.