Bake Cake

Renewed Warnings about ETFs: Volatility Baked into the Cake?

Bake Cake

The popularity of exchange-traded funds (ETFs) keeps rising. By some estimates, ETF assets are projected to soar past $4 trillion this year as big industry players like BlackRock, Invesco and State Street continue to build their pipelines and create new funds.

The Wall Street Journal, however, warned in an article (March 2019) that during down markets "ETFs could make things even worse." Markets reporter Simon Constable pointed to research that indicated "the proliferation of exchange-traded funds could create problems in a volatile market."

As we've noted in the past, it's important to realize that ETFs are designed as trading vehicles. Increased numbers flooding the U.S. marketplace is renewing concerns, according to the paper, about how big institutional traders and brokerages are creating liquidity and value on a daily basis for these funds.

"In short, while ETF market makers are required to own the shares that make up the basket of stocks the funds represent, rules allow them to sell shares that they don't already own, similar to so-called shorting, on the presumption that they will purchase those shares later," the WSJ article ("In a Down Market, ETFs Could Make Things Even Worse") observed. "Settlement of these trades, however, does not always happen quickly."

When market volatility is particularly turbulent, some analysts have complained so much "operational" shorting activity takes place that "the number of shares of certain stocks reflected in the total volume of these trades can exceed the number of shares that actually exist," according to the WSJ story.

"The reason there is more risk is that the ETF market makers can transact among each other and those trades aren't required to be settled immediately," explained Rabih Moussawi, a Villanova University finance professor. Along with three other academics, he co-wrote "ETF Short Interest and Failures-to-Deliver: Naked Short-Selling or Operational Shorting?" (April 2019). 

The report uncovered eye-raising levels of operational shorting, both over shorter- and longer-term periods. It used regression analysis and compared ETF activities with trading in common stock shares over an extended timeframe from early 2004 through 2017. Researchers found that in 2016 alone, 78% of all failure-to-deliver (FTD) instances in U.S. securities markets came from ETF-related transactions. That was up from 72% a year earlier, the paper adds.

In this regard, FTDs are described as "electronic IOUs" where a market participant who has "engaged" in a short sale doesn't deliver the underlying security at the time of settlement. In the U.S., this period is characterized as normally taking up to two days after the transaction date, and referred to as "t 2" by securities trading professionals.

The graph below shows data collected by researchers comparing rolling-average daily dollar values of what they characterized as "operational" shorting activities and FTDs for ETFs during a nearly 13-year period. Of course, market conditions change and such tendencies aren't guarenteed to continue into future decades. Still, this study raised concerns about past patterns in which as shorting related transactions increased, so did the dollar amounts of failure-to-deliver activities in ETFs.

Fig1_Operational Shorting and Failure to Deliver Activity of ETFs

The paper cautioned that overall growth in the volume of FTDs can lead to increased trading risks with ETFs in terms of impairing some "market participants' ability to meet their other obligations in a timely way, leading to greater counterparty risk."

This isn't the only piece of research to question whether trading in ETFs can increase risks for investors when market conditions are in flux. Separately, a study ("ETFs Track Liquidity Risk on top of Asset Performance") published by Moody's Investors Service (May 2019) noted periods in which banks refrained from providing market liquidity for certain bond ETFs. As a result, under such conditions trading in these types of funds became more expensive and volatile for investors.

"We're looking at a changing environment where the traditional banks that acted as market makers have stepped away from the scene," Fadi Abdel Massih, a Moody's analyst who authored the report, told Institutional Investor in reviewing his research team's findings.

Of course, such a lack of institutional liquidity and support for bond ETFs could turn out to be a relatively transitory development. The way these funds are structured and traded on a daily basis, however, is credited by Moody's researchers as lending credence to their heightened view that investors would be well-served to tread cautiously with bond ETFs amid any severe market downturn. 

"In effect, ETFs track not only the performance of their underlying assets, but also the liquidity of these assets," Moody's study related. "Therefore ETFs targeting illiquid instruments, such as corporate bonds and leveraged loans, would present greater risks, and investors trading on the premise that ETFs are more liquid than their baskets may find that results fall short of expectations in a stressed environment."

These most recent pieces of research help to support IFA's view that ETFs are best served as placeholders or alternatives when traditional passively managed mutual fund options are limited in a particular asset class or global marketplace.

While our research staff continues to monitor leading ETFs with high levels of liquidity, we prefer traditional mutual funds that are designed for long-term investing, not short-term trading. The operational differences, borne out by our own real-life experiences in working with clients, underscore how important it is to choose not only the best designed index, but also the most risk-appropriate open-end mutual fund.

Sources: "In a Down Market, ETFs Could Make Things Even Worse," (March 3, 2019), Wall Street Journal. "ETFs tarck liquidity on top of asset performance," (May 9, 2019), Moodys' Investors Service. "ETF Short Interest and Failures-to-Deliver: Naked Short-Selling or Operational Shorting?" (April 2019), University of Virginia-- Darden Business School.
This article is distributed for informational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services. There is no guarantee investment strategies will be successful.  Investing involves risks, including possible loss of principal.