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ETF, WTF?

Regulators – both in the USA and Europe – are voicing concern over exchange traded fund liquidity

October 13, 2019

2:25 PM

13 October 2019

2:25 PM

Exchange traded funds (ETFs) are booming. But there are rumblings among regulators about the potential systemic risk they pose to markets. As a minority sport becomes major league, ETFs are under increasing scrutiny.

Why pick an ETF over a vanilla mutual fund? Foremost, they offer a cheap way for small investors to invest in esoteric products difficult to access, such as commodities. Take gold. Twenty-nine gold ETFs trade in the US, with $81bn assets under management (AUM).

How cheap? The industry bible, Morningstar Investment Research’s latest research reports average ETF fees at 0.44 percent against traditional index funds at 0.74 percent.

Some ETFs are now being offered with 0 percent fees. Fidelity, an asset manager with $2.4 trillion under management, pioneered zero rated ETFs in Fall, 2018. The majority of ETFs are passive, following indexes, lowering costs for managers.

ETFs address two drawbacks of conventional open and closed end funds – liquidity and discounts. They trade like ordinary stocks – intraday – unlike conventional open end mutual funds, which fix a price at the close of the trading day. Simply, if you instruct the sale of an open end mutual fund stock at 10:00am, the price you receive at 4:00pm may have shifted.

Second glitch. In a closed end mutual fund, the fund assets are owned by a company whose shares are traded by investors intraday, like a conventional stock. So far, so much better. But, the share price (SP) may not reflect the full value of the basket of assets owned by the company – the net asset value (NAV).

These shares can trade at a premium, more commonly they trade at a discount to NAV – sometimes a whopping 20 percent. $100 of assets in the funds will be reflected in a fund share price of only $80, so if you bought the funds at their original value of $100 you would lose 20 percent of capital on selling. That’s because many quoted closed end mutual funds are small, thus illiquid and price inefficient.

ETFs combine the intraday trading feature of closed end funds with the true asset valuation feature of open end funds. The discount is all but eliminated, because, as soon as a basket of ETF shares is offered for sale the price is matched by someone in the market willing to buy it. Spreads between buying and selling prices are tight and always being re-set.

This is how it works. Fund managers, who are ETF distributors, buy or sell ETFs directly from or to authorized participants (APs), large broker-dealers with whom they have contracts, not in individual , difficult to trade, packets, but in creation units, large blocks of tens of thousands of ETF shares, usually exchanged in-kind with baskets of the underlying securities.

APs usually act as market makers on the open market, using their ability to exchange creation units with their underlying securities to provide liquidity and help ensure the intraday market price trends close to the value of the underlying assets.

When did you last hear, ‘too good to be true’? Oh, yes, that would be around 2008, shortly after The Economist ran a cover story about globally securitized assets signaling ‘the end of risk’ Didn’t end well. Small wonder regulators are pricking their ears up as ETFs become systemically significant.

Regulators – both in the USA and Europe – are voicing concern over ETF liquidity. Increasing market volatility has re-ignited fears about how the $4 trillion US ETF industry might react in a crunch.

There was a foretaste in the 2010 Flash Crash, when an electronic glitch meant orders from market makers were erroneously withdrawn, implying there was a 1$ trillion sell off. The unspoken question – what if market makers, or APs, were to withdraw for real?

Here’s the perfect storm. Volatility prompts market-makers to withdraw when they’re needed most, blowing out transaction costs and freezing trading. APs are unlikely to withdraw, as they are under contract. But market makers, who live by their wits, could push off.

Department of explanation. Market makers working alongside the APs – who agree to fulfill buy and sell orders, are the oil in the machinery, making intraday trading work, There is no fee for taking on risk. Money is made from smart pricing decisions, clipping profit from the difference between buying and selling prices – the spread.

Market makers commit capital to cover potential losses and, as the ETF market has grown, that commitment has become greater. Reggie Browne, the Godfather of ETF market making, who made his name at Cantor Fitzgerald finance group, told me there are currently around 40 market makers in the business, but they occasionally withdraw from trading when capital limits are tested.

He has led the debate about capital adequacy. Today’s automated markets offer a data rich environment and market makers can rely on decades of data mining about market behavior to mitigate risk. Yet, there is nothing to compel them to trade if markets turn.

One potential cure is a practice that’s commonplace in Europe, but banned in America; ETF providers paying market-makers directly. The argument goes that the potential conflict of interest concerns that prevent it now are misplaced. Regulatory oversight will prevent price gouging.

While US regulators maintain a discreet silence, it’s a hot topic at industry conferences heading into fall. It’s on the agenda of the Independent Directors Council (IDC) conference in Chicago next week.

There is growing support for Mr Browne’s argument that market-making agreements – already permitted in Europe – would encourage continued support in times of turbulence.

The glitch is, that would involve market makers raising and committing more capital, though that would be easier on the back of guaranteed income – a reasonable trade off for turning down the risk dial on systemic failure.

Gerald Malone is chairman of a range of US mutual funds and a director of The Mutual Fund Directors’ Forum (MFDF) in Washington DC.


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