Wealth Manager - the site for professional investment managers

Register free for our breaking news email alerts with analysis and cutting edge commentary from our award winning team. Registration only takes a minute.

Could ETFs contribute to the next recession?

Could ETFs contribute to the next recession?

Exchange-traded funds (ETFs) saw net inflows of £1.1 billion across Europe in October, despite the market sell-off, but questions are now being asked about the extent to which passive investment will contribute to bubbles forming or even the next recession.

Although ETFs have won favour for their transparency, cost-effectiveness and ease of use, Mike Horan, head of trading at Pershing, has highlighted their capacity to warp large cap indices and reduce the attractiveness of small caps.

He said: ‘Such considerable flows into these instruments – ranging from tracker funds to ETFs – do not come without complications. It has contributed to an artificial inflation of large cap indices, while also diverting liquidity away from the smaller cap stocks, meaning they are harder to trade and invest in. 

‘The challenge is that if there is a market shock or correction, which is possible given the length of the equity bull market, it is going to be very difficult for the market to take the weight of a large scale selling of passive instruments. This is even more the case in the less liquid fixed income market.’

Horan added: ‘Having enjoyed the market rally over the past decade, passive investors are now facing macro headwinds they have not previously encountered through rising inflation and increased market volatility.

‘Therefore, when a rush to the exit comes, it remains to be seen what kind of position we will be left with.’

 

Standing firm

 

In contrast, BlackRoc’s analysis of ETF behaviour over the four day period from 5 February, when markets sold off heavily, found that they withstood global market volatility and suffered only minimal investment withdrawals.

Using figures from Bloomberg, BlackRock identified only $30 billion (£23.6 billion) in net ETF outflows over this period, despite heavy stock and bond ETF trading of $1 trillion in that period. ETF flows accounted for 3.86% of total US equity trading volumes during this period, down from an average of 4.32% in 2017.

Rather than accelerate stock price moves, heavy ETF trading was less influential on the US equity market than average.

Overall, ETFs traded with heavy volumes and high liquidity. They acted as ‘shock-absorbers’, enabling buyers and sellers to do business in the secondary market at market determined prices, BlackRock found.


Uncertain times


Joe Parkin, BlackRock’s head of iShares and digital wealth in the UK, the Netherlands and the Nordics, said that he and his peers had noticed many investors buying into ETFs in uncertain times.

He said: ‘What we often see in times of market stress is an increase in ETF trading volumes – or how often they change hands – and demand for our products, because people want to use ETFs to manage their risk and liquidity.

‘For example, we are seeing demand for sterling-hedged international equity ETFs in the UK off the back of concerns around the government vote [on the Brexit withdrawal agreement] next week.

Larry Hatheway (pictured, chief economist at GAM, also believes ETFs lacked the characteristics to be a likely contributor to a future downturn.

He said: ‘ETFs are like other funds and do not embed particular risks that would make them more prone to be the precursors of the next cyclical downturn or recession.’

He also pointed out that while they are widely held, there is no reason why they would be more likely to be sold in a downturn than an active fund.

According to BlackRock, one recent tally found that ETFs represent around 4% of the global equity market by market value. ETFs and index funds combined make up just over 12% of US equity holdings.

 

Worst-case scenario

 

But Hatheway said that in an extreme environment for the more illiquid end of the credit market, ETFs could potentially cause issues, affecting the cost of debt finance and difficulties for market makers.

‘Fund structures, including ETFs, that offer daily dealing or short-term access to liquidity, but which hold potentially illiquid assets, such as some corporate credit, could pose special risks, which in extremis could lead to a sharp jump in the cost of debt finance or challenges in rolling over debt,’ he said.

‘That is because the underlying holdings of the ETFs and similar funds might not find ready buyers in the event of significant selling pressure. A key reason is the inability of market makers, including investment banks, to warehouse credit instruments, given high capital and regulatory costs of doing so.

‘It is therefore possible to imagine significant market dislocations in the event redemptions were to rise sharply.’

However, Parkin said that this was highly unlikely. He noted that ETFs made up just 1.4% of the US bond market, as an example of their relative size.

He also said that it was ‘nonsensical’ to argue about active or passive, as it was asset allocation decisions that sparked the sale of an asset class, and ETFs were just one tool to access that.  

Leave a comment!

Please sign in or register to comment. It is free to register and only takes a minute or two.

Related Fund Managers

Larry Hatheway
Larry Hatheway
12/28 in Mixed Assets - Conservative USD (Performance over 1 year) Average Total Return: 3.99%
Citywire TV
Play Citywire 20: Investec's du Toit on managing the 'jerk factor'

Citywire 20: Investec's du Toit on managing the 'jerk factor'

Investec boss Hendrik du Toit believes he has become far more decisive over the last 20 years, especially when it comes to managing 'jerk' factor.

Play Citywire 20: Hugh Young's bleak lesson

Citywire 20: Hugh Young's bleak lesson

In the latest video to mark Citywire's 20th birthday, Aberdeen Standard Investments Asia head reminisces about one of the toughest periods in his career.

Play IWD 2019 video: fund and wealth figures define diversity

IWD 2019 video: fund and wealth figures define diversity

To mark International Women's Day, we have spoken to a variety of top fund houses and wealth managers about their definition of diversity, and how they hope to achieve a more inclusive workplace.

Read More
Wealth Manager on Twitter