ETF volatility: truths and misconceptions

Exchange-traded funds (ETF) are widely attacked every time there’s any sort of volatility in global financial markets. Losing money is never much fun and investors can easily blame someone or something else when it all starts to go pear-shaped.

But just like it’s not a good idea to shoot the messenger – they are simply delivering the bad news, they aren’t responsible for it – it’s the same when it comes to investing.

If the Australian share market falls, so too will the ETF that tracks the top 200 stocks in the benchmark S&P ASX 200 Index. It’s meant to do that.

For sure investors will lose and that will be reflected in the ETF, but take a look why.

Poor earnings, the performance of the economy, the prospect of trade and currency wars, political tensions and interest rates can all lead to losses.

Those losses will be reflected in the ETF.

But, of course, if the share market goes up, so will the ETF. Investors will be making money.

ETFs are growing in popularity in Australia as more investors understand that gaining exposure to certain asset classes and regions can be done easily and cost efficiently through ETFs as opposed to other more traditional vehicles.

Lowering the cost of running portfolios and reducing risk by investing in funds that hold multiple companies (normally 30 or more) has become the foundation of prudent portfolio management.

This, coupled with the ease with which investors can now get exposure to certain asset classes and regions, has resulted in ETFs becoming the fastest-growing product type in Australia, with over $37 billion in funds under management, and this is likely to accelerate.

However, with this growing adoption of ETFs have come various criticisms, with one of the most consistent being that ETFs are causing market volatility and reacting differently to the underlying securities they track.

The reality is that, in nearly all cases, ETFs do what they’re supposed to do, which is to track the underlying basket of securities set by the index.

If the underlying market is volatile, the ETF should be volatile, and if the ETF isn’t exhibiting the same level of volatility as the underlying market, investors should be very wary. Ultimately the ETF is just a wrapper for the securities underneath, so it should transmit the characteristics of those securities faithfully.

Additionally, it is worth considering that having a fund that is open ended and trading during market hours has huge benefits in terms of investors’ risk mitigation.

During the global financial crisis (GFC) there were many hedge funds around the world where the sell price wasn’t transparent.

It would often take several days/weeks more than expected to be provided and, often, investors weren’t even able to sell their position as the funds ‘gated’ investors, that is, they put a halt on redemptions.

This wasn’t the case for ETFs, with ‘gatings’ still being a very rare event. Most investors nowadays don’t consider such risk aspects, but nothing was more important to many investors during the GFC than having the ability to sell.

A closely related accusation to the above discussion on general ETF volatility is that certain ETFs are so big, relative to the underlying market they track, that they can move the market. The assertion is many investors buy (or sell) the ETF covering a certain market/theme and in doing so force automatic buying of the underlying securities by the market makers who need the securities to give to the ETF provider to create new units.

In Australia, the size of ETF trading is very low compared with other regions, so it’s unlikely any ETF has an effect on the underlying market it may track. However, in the United States there are several ETFs where this may be the case.

The truth is that where the demand for the ETF is high versus the standard trading volumes for the underlying securities, there can be movement on the underlying securities over and above their normal range.

This movement occurs because the underlying market needs to absorb the additional demand. Market makers achieve this by making the price of the securities more expensive as is the case in any demand/supply situation where demand exceeds supply and therefore the participant with the supply can demand a higher price.

Crucially, this is not just the exclusive domain of ETFs, which have taken far too much of the blame for this.

As mentioned several times, the ETF just tracks a basket of securities. If the ETF didn’t exist, the investors, who have the same demand, would elect to buy the same, or similar, securities either as a direct basket or via an active manager’s fund.

This is, in fact, exactly what is happening every day. Investors interested in a region or theme may elect to buy a basket of securities or buy an active fund or buy an ETF. All three will have an almost identical effect on the underlying market.

The only difference is ETFs are listed and therefore transparent for all to see. Due to this, they are targeted as the sole cause precisely because they’re visible and the causal link between the ETF and the underlying securities is easy to see, that is, high levels of ETF buying must equal high levels of underlying security buying.

On the other hand, it’s not easy to discern what is causing non-ETF-related purchases as there is nothing to indicate the motives behind other buying.

Put simply, ETFs are blamed as they’re easy to point the finger at. In actual fact, much of the volatility can be caused by activity that has nothing to do with ETFs.

Putting this in even starker perspective, in the US market, where ETFs trade the most in the world, they still only make up, on average, 25 per cent of the trading volumes, meaning 75 per cent of trading volume, three-quarters of the market activity, has virtually nothing to do with ETFs at all.

ETFs have been unfairly targeted because they threaten many traditional product sets in asset management and because they are transparent and trade on exchange, they become easy to attack.

But don’t shoot the messenger.

Most of the evidence shows the attacks are unfounded and, in fact, ETFs continue to present a fantastic option for investors where liquidity, access, cost and transparency are important foundational principles.

Kris Walesby is head of ETF Securities Australia.

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