Understanding the reality of ETFs
Sweeping developments within the investment management industry are putting Exchange Traded Funds (ETFs) on course to potentially gather more assets over the next five years than in the previous 25 years combined. With global ETF assets currently totalling US$5.7 trillion, they are poised to more than double to US$12 trillion by the end of 2023.
Australia’s ETF market is following suit, having recently exceeded AU$50 billion AUM on the ASX. As the ETF market continues to grow in Australia, I answer ten common questions about the market realities of ETFs.
1. HOW DO ETFS IMPACT MARKET LIQUIDITY?
Exchange Traded Funds (ETFs) are unique; they provide exposure to a diversified collection of assets, like a managed fund, but trade on exchange, like a stock.
This structure makes the liquidity of ETFs unique, too. Liquidity refers to the ease of buying or selling a stock, and ETFs provide two layers of liquidity to the market. The first is primary market liquidity, which is provided by the underlying securities or instruments of the ETF. The second layer is secondary market liquidity, which is provided by the ability to trade ETFs on exchange.
This means ETFs are net contributors to market liquidity. At a minimum, an ETF will be as liquid as its underlying securities or instruments; often, however, ETFs provide even greater market liquidity than their underlying instruments.
2. DO ETFS DRIVE THE DIRECTION OF MARKETS?
Given the size of some of the largest ETFs in overseas markets, one might think that buying and selling within those funds actually moves market prices.
In fact, asset allocation decisions made by asset owners, such as pension funds and individuals, drive flows into different asset classes, sectors and geographies. Their allocation decisions are guided by factors such as macroeconomic developments (like global interest rate policy), risk preferences and investment horizon.
ETFs are just one way for investors to express their views about the market. If ETFs didn’t exist, investors could use other tools, like single stocks, managed funds and derivatives.
3. HOW BIG IS THE ETF MARKET?
As of 16 July 2019, there were $5.7 trillion of ETF assets worldwide. This means that ETF assets represent approximately five per cent of global market capitalisation, or the dollar value of the global market. Even within the United States – the largest ETF market – just nine per cent of the total assets invested in US equities are in US-listed equity ETFs. The fixed income ETF market is even smaller, at 1.6 per cent of the total US bond market.
Coming back to the Australian domestic market, while ETF assets are growing quickly, Australian equity ETFs currently represent just under one per cent of the total assets invested in the Australian equity market
4. DO ETFS INCREASE MARKET VOLATILITY?
No. In fact, ETFs have acted as “shock absorbers” during many volatile trading sessions as buyers and sellers transact on the exchange, at real-time prices, without having to trade the underlying stocks and bonds.
What’s more, since ETF shares are traded directly by buyers and sellers on-exchange, an ETF can circumvent ‘forced selling’; something a managed fund may need to do when investors want to sell their shares. This means the underlying securities may remain intact.
5. ARE ALL EXCHANGE-TRADED PRODUCTS THE SAME?
While all exchange traded products share certain characteristics, some have embedded structural risks that go beyond the scope of ‘plain vanilla’ ETFs.
BlackRock defines an ETF as a publicly offered investment fund that:
- Trades on an exchange
- Tracks underlying securities of stocks, bonds or other investment instruments
- Does not seek to provide a leveraged or inverse return
- Gives daily transparent holdings to all market participants
BlackRock, along with others in the industry, has called for a clear-cut ETF naming convention to better serve investors.
6. DO INDEX REBALANCES MAKE INDEX INVESTING LESS EFFICIENT?
Indexes are periodically rebalanced as changes in market prices affect the relative weightings of individual securities. Funds that track indexes are professionally managed, and there’s a lot of work that goes on behind the scenes by skilled professionals to make sure these publicised events are smoothly executed.
- Some funds use knowledge of the indexing process to capture price movements or lessen any temporary price effects by trading in names added to the index. Others may try to capture information by predicting inclusions and deletions.
- Competition ensures any indexing effects are modest, however. It is not easy to beat index benchmarks.
7. DOES INDEX INVESTING INCREASE ASSET PRICE CORRELATION?
Correlation measures the degree to which two securities’ prices move in relation to one another. Correlation between stocks has risen in recent years, giving rise to a misperception that the growth of index funds is the cause; in other words, that the unique, fundamental drivers of individual stock prices are being superseded by their inclusion in an index.
There are other, more plausible causes for increased correlations in stock and other asset prices, including macroeconomic factors such as global interest rate policy or the price of raw materials, which can cause asset prices to move in tandem, and heightened market volatility, as we saw during the 2008 Global Financial Crisis.
8. HOW DO ETFS IMPACT STOCK PRICES?
Questions sometimes arise about whether ETFs influence the prices of the stocks they hold. In short, not all ETF activities affect the market prices of underlying stocks via a buy or sell in the underlying markets.
When ETF trading increases, the activity on the underlying stock does not increase proportionally. In the largest ETF market in the US, on average approximately five per cent of trading in individual stocks is attributable to ETF flows. This is because 90 per cent of ETF activity takes place on-exchange between buyers and sellers of ETF shares, which means that – most of the time – shares of underlying stocks do not need to be bought or sold to adjust for changes in investor demand.
9. WHAT WOULD HAPPEN IF AN AUTHORISED PARTICIPANT OR MARKET MAKER WITHDREW FROM THE ETF MARKET?
An authorised participant (AP) is a financial institution that manages the creation and redemption of ETF shares in the primary market. Each AP has an agreement with an ETF sponsor that gives it the right (but not the obligation) to create and redeem ETF shares. APs may act on their own, or on behalf of market participants.
Market makers are broker dealers that regularly provide two-sided (buy and sell) quotes to clients on the exchange. In some instances, an ETF’s market makers may also be APs.
APs and market makers operate in a highly competitive environment and are economically incentivised to take part in making or trading ETF shares. If an AP or market maker were to withdraw from the ETF market, other APs would likely step in to facilitate the creation and redemption of ETF shares.
With transparent ETFs, the ability to exchange the ETFs for either cash or the underlying assets provides economic incentives for market makers to trade when the price deviates from the value of the underlying assets. This self-policing mechanism ensures the exchange price does not materially deviate from the values of the fund’s assets. Any drifting in the price of an ETF away from the current value of the ETF’s portfolio of securities will economically incentivise market makers due to the fact that profit can be made by selling the higher-priced asset while simultaneously buying the lower-priced asset. We term this the ‘ETF arbitrage mechanism’.
Ultimately, it is this arbitrage mechanism that helps keep the ETF market price close to the value of its underlying holdings each day.
10. WHAT ROLE DO ETFS PLAY IN PRICE DISCOVERY?
Price discovery helps investors identify the proper market price of securities or other instruments based on factors like supply and demand. The on-exchange trading of ETFs plays an important role in price discovery across markets, sectors and individual stocks. For example, international ETFs traded during Australian market hours help investors set prices daily when non-Australian markets are closed. Additionally, during suspensions of international stocks or markets, AUD-domiciled ETFs could be the primary source of pricing information available to market participants.
ETF flows provide crucial information. As greater numbers of sophisticated investors use ETFs to express their views, flows from one asset to another can serve as indicators of investor sentiment about potential risk and return.
Note that ETFs don’t set prices or drive volatility. They hold up a mirror to what investors are thinking.
For example, the iShares Core MSCI Emerging Markets ETF (IEMG), a US-listed ETF that seeks to track an index of emerging market equities, traded almost 2.5 times more than its daily average on days when the status of US and China trade talks changed through the end of 2018.
Christian Obrist is head of BlackRock's iShares business in Australiasia
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