ETFs: Are they too big to fail?By Jim Pratt-Heaney
“Our experience on Wall Street has taught us to be wary of new financial vehicles hailed as the answer to modern investing.”
Our experience on Wall Street has taught us to be wary of new financial vehicles hailed as the answer to modern investing. In the last 20 years, no investment product has grown in assets more than the exchange traded fund (ETF). This impressive growth might suggest that ETFs add tremendous value for investors, but we’d suggest taking a closer look.
In 1993, when State Street Global Advisors introduced the SPDR ETF to track the S&P 500 index, the issue size was $6.5 million. Today, the ETF market has over 1,600 ETFs, representing over $2.7 trillion. This sort of growth is not without market consequences. Consider:
- $18.2 trillion worth of ETF shares were traded over a 12-month period from July 2014 to July*
- Over the same 12 months, ETF annual turnover was 870 percent, versus 200 percent for the average stock, and 35 percent for mutual funds*
- 75 percent of ETFs are held by institutions for hedge or portfolio construction purposes, not long-term investment**
Most investors know an ETF is a “basket” of stocks, bonds, commodities or other asset classes. In fact, this range has ballooned to include lever- aged and synthetic varieties. Among other reasons, ETFs vary from their mutual fund cousins due to their ability to be traded throughout the day. While this provides theoretical liquidity, it also introduces risk in attempting to price an aggregation of securities on a real-time basis based upon buy-sell order flow.
So, what can go wrong? An analogy is a movie theater with clearly marked exits. Yet, in stressful situations, those same exits cannot handle the flow of traffic in an efficient, safe manner. Looking back at the market volatility of August 2015, we saw ETFs trading as much as 30 percent lower than the true value of their holdings; there were even temporary trading stop- pages because market makers could not follow the rules to maintain an acceptable price. As part of LLBH’s financial review, we evaluate prospective clients’ investments to discover potential portfolio concerns. We often find portfolios loaded with ETFs and have identified important questions to consider:
- Diversification: We advise a diversified portfolio, not a basket within a certain asset class.
- Position overlap: Oftentimes, different ETFs hold the same underlying securities, exposing investors to potential company or sector risk.
- Fees: While popular due to their discounted pricing, many ETFs’ fees have risen.
- Performance relative to bench- marks: Difficulty with replication has resulted in fixed income ETF under- performance versus benchmarks, some by more than 5 percent***
- Are benchmarks appropriate? Some actively managed ETFs don’t have a real index or benchmark to fol- low, making them difficult to evaluate****
- Is there potential for trading issues? The bond market sell off of 2013 highlighted the impact of rapid movement of money in and out of fixed income*****
Our aim is not to deride ETFs as a poor investment vehicle; ETFs can play a role in a well-formed portfolio. But, as an investor, you should be aware of their underlying issues and recognize that while there may be a lot of assets committed to the category, ETFs are not too big to fail.
*Eric Balchunas. Bloomberg.com, http://www.bloomberg.com/news/articles/2015-07-30/the-amount-of-etf-shares-being-traded-has-eclipsed-u-s-gdp: paragraph 3, July 30, 2015;
**Jane Wollman Rusoff. Research magazine: “How John Bogle Really Sees ETFs,” October 2012;
***Bloomberg Data, cumulative performance versus benchmark, January 1, 2009, to June 1, 2015;
****Investor.gov, Investor Bulletin: SEC Exchange Traded Funds, August 2012;
*****Massoudi, Arash, Braithwaite, Tom and Foley, Stephen. Financial Times, “Bond market sell-off caused stress in $2tn ETF industry,” June 21, 2013.
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