ETFs' Trillion Dollar Market Prompts Regulatory Scrutiny of Fire Sale Risk

The numbers associated with exchange-traded funds (ETFs) seem to get bigger every day. One of the latest stats comes from Broadridge Financial, which pegs the total at some $2.2 trillion in 2015. Another figure that includes ETPs (exchange-traded products) puts the global market at just a whisker shy of $3 trillion, according to London-based consultancy ETFGI.

“The record level of asset gathering in 2015 shows that more investors are using ETFs/ETPs in more ways due to the market turmoil: retail is using more ETFs through robo-advisors, institutions are using ETFs as alternatives to futures, and financial advisors are using more ETFs especially in multi-asset portfolios,” said Deborah Fuhr, Managing Partner of ETFGI, in a released statement.

Regulators will be focusing on ETFs in 2016, that is for certain

Not surprisingly, regulators are taking a closer look at potential risks.

“Regulators will be focusing on ETFs in 2016, that is for certain,” writes US-based consultancy Finadium, in a report to be released in February made available to Finance Magnates.

Finadium’s research showed that ETF assets are concentrated with the top players - the top 100 funds control $1.57 trillion, or over 50%, of total ETF assets, while the top 10 funds in particular control $585 billion in assets. That means these funds alone could cause broader ripples throughout the markets.

“We observe that ETF managers and their products are not an inherent problem, but that market structure combined with new Liquidity Liquidity The term liquidity refers to the process, speed, and ease of which a given asset or security can be converted into cash. Notably, liquidity surmises a retention in market price, with the most liquid assets representing cash.The most liquid asset of all is cash itself.· In economics, liquidity is defined by how efficiently and quickly an asset can be converted into usable cash without materially affecting its market price. · Nothing is more liquid than cash, while other assets represent The term liquidity refers to the process, speed, and ease of which a given asset or security can be converted into cash. Notably, liquidity surmises a retention in market price, with the most liquid assets representing cash.The most liquid asset of all is cash itself.· In economics, liquidity is defined by how efficiently and quickly an asset can be converted into usable cash without materially affecting its market price. · Nothing is more liquid than cash, while other assets represent Read this Term and Volatility Volatility In finance, volatility refers to the amount of change in the rate of a financial instrument, such as commodities, currencies, or stocks, over a given time period. Essentially, volatility describes the nature of an instrument’s fluctuation; a highly volatile security equates to large fluctuations in price, and a low volatile security equates to timid fluctuations in price. Volatility is an important statistical indicator used by financial traders to assist them in developing trading systems. Trad In finance, volatility refers to the amount of change in the rate of a financial instrument, such as commodities, currencies, or stocks, over a given time period. Essentially, volatility describes the nature of an instrument’s fluctuation; a highly volatile security equates to large fluctuations in price, and a low volatile security equates to timid fluctuations in price. Volatility is an important statistical indicator used by financial traders to assist them in developing trading systems. Trad Read this Term trends could combine to make ETFs the center of a new fire-sale risk problem,” according to the report.

Still, not all ETFs are liquidity equal.

A truly active ETF, for example, does not behave and perform the same way as liquid trackers, said Matt Holden, Managing Director, Head of ETF Trading Europe at Cantor Fitzgerald, speaking at a recent event organized by the Chartered Institute for Securities and Investment (CISI): “You’ll never have a situation whereby you actually have the (active ETF) being the tail that wags the dog…where people come in and start trading (it) in more shares than what the underlying asset is.”

Active providers tend to broadcast their portfolios only to a select group of partnering market makers, which means less visibility into what’s being traded. As a result, liquidity provision to the market can be a bit murkier, albeit with the upside of wider spreads.

Then, there are smart beta groups, which follow completely transparent investment strategies not based on market capitalization. Smart beta, also known as alternative beta and factor investing, is often described as the middle ground between passive and active investing. The strategies have received a great deal of attention in recent years.

WisdomTree Asset Management, also presenting at CISI’s seminar, invests in and provides alternative beta products, focusing on dividend-weightings. Liquidity, said Christopher Gannatti, Associate Director at the firm, is baked into the design.

...market structure combined with new liquidity and volatility trends could combine to make ETFs the center of a new fire-sale risk problem

When Gannatti joined in 2010, AuM was at some $8.5 billion in the US. That’s grown to $45 billion at the beginning of this year with presence in Europe and Japan.

“When WisdomTree designs the smart beta index, it has liquidity and tradability on the mind from the first step of index construction,” Ganatti said, speaking to Finance Magnates. “It is a long only equity focused strategy, and what it’s doing is buying some of the largest and most liquid stocks.”

For smaller, less liquid stocks however, liquidity of the underlying asset can trump that of the ETF. That’s because when a trade starts to get past a certain size, particularly in the small- and mid-cap field, there will be more market makers going into the underlying asset.

Cantor’s Holden said that for an index like the FTSE350, anything over £15 to £20 million in size is going to be a situation “where you are then moving away from the inherent liquidity of the ETF and purely looking at the underlying liquidity, and what can be filled in that sense”.

The outcome of regulatory scrutiny remains to be seen, and there are question marks over the impacts to cost of trading and how wide the net will be cast. Considering the size of the market it does seem welcome and timely, particularly when it comes to options on ETFs and leverage, as well as the use of ETFs as collateral.

“ETFs are attractive for reasons of simplicity, cost and convenience. The liquidity and volatility of their underlying markets are not what they used to be, however, which magnifies the need to break or limit opportunities for risk transmission,” wrote Finadium.

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