It is often said that criticism is the price of success. This certainly appears to be the case with exchange-traded funds, which have enjoyed tremendous growth over the past few years but are the recipient of frequent criticism. Criticism has come from various quarters, but there is some unease that it often comes from individuals outside the industry who perhaps do not grasp all the technical intricacies of the product or from parties whose vested interests may be under threat (think traditional mutual fund managers earning big fees).

This week, Portfolio Adviser magazine featured an interview online with Helen Thomas, the founder of BlondeMoney, a macroeconomic consultancy, under the title ‘ETFs could spark next financial crisis’.

In the interview, which was conducted by LiquidiTV, Ms Thomas claims that “ETFs were a great idea” (note “were”, not “are”) but “contain a design flaw” and says “the ETF market is now just too unwieldy” and has created “an unstable market structure”. For good measure she compares them to CDOs.

Quite a charge sheet!

Ms Thomas’s views were also carried in The Economist’s Buttonwood column.

Now, it could be argued that this publication (ETF Strategy) has an interest in the success of the ETF industry. And of course we do. Nevertheless, we were concerned that the claims didn’t quite stack up and fell short from a technical standpoint. So we asked leading industry experts what they thought, with particular reference to the operational mechanics of ETFs.

Below, we carry Ms Thomas’s response to each question in full and counter with the views of our experts – Hector McNeil, Co-CEO of HANetf; Caroline Baron, Head of ETF Sales, EMEA, at Franklin Templeton; Adam Laird, Head of ETF Strategy, Northern Europe, at Lyxor ETF (Adam is also chair of the ETF committee at The Investment Association); and Marcus Miholich, Head of ETF Capital Markets, EMEA and APAC for State Street Global Advisors.

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What do you think the issue is with ETFs?

Helen Thomas, Founder, BlondeMoney:
“ETFs were a great idea. They combined the investment into a fund with the ability to trade it at any time on an exchange. Instead of buying 500 stocks in the S&P, you could buy the SPY ETF, which closely tracks the performance of all those stocks. Same returns, but cheaper and more efficient; what’s not to like? The reality is that they contain a design flaw. The tracking process comes about because market makers arbitrage away differences in price, between the underlying and the ETF. If they deviate, there should be a risk-free return because they’re the same thing, right? But, arbitrage only works when there is liquidity. And the liquidity in an ETF is dependent on the market makers and their creation agents, the APs (Authorised Participants). They aren’t obligated to make a price, and if it’s too hard to get hold of, say, a high yield bond, then they step away from pricing, say, the HYG ETF. It’s nothing to do with BlackRock or Vanguard; they’re just the shop front. If you go in to buy some chewing gum, it won’t be there if the suppliers stop delivering.”

[pullquote]“APs and market makers are obliged via contract and exchange rules to guarantee two-way pricing throughout the trading day, and in the majority of cases there are multiple market makers competing for each trade.”

– Hector McNeil, Co-CEO, HANetf.[/pullquote]Hector McNeil, Co-CEO, HANetf:
“ETFs remain a good idea and the majority of allegations regarding liquidity can be made equally, if not even stronger, for mutual funds and other investment products. APs and market makers are obliged via contract and exchange rules to guarantee two-way pricing throughout the trading day, and in the majority of cases there are multiple market makers competing for each trade. If your alternative to an ETF is to buy a basket of equities or bonds directly, you are still in the same position if there is no liquidity – no bids for your bonds means you can’t get out or vice versa. The point that seems to have been missed is that even when liquidity is low, ETFs provide investors with more trading flexibility, transparency of pricing and immediacy of execution than traditional fund products.

“The point about arbitrage is mistaken. The arbitrage exists because the ETF is open ended and if any investor, not just market makers, see any mispricing then they can trade that away. This effectively means an investor at any time during the trading day effectively gets a real time NAV and doesn’t have to worry about premiums and discounts that you get in the market via other financial instruments, including mutual funds.

“It should also be noted that all creation and redemptions are done at the net level and not gross like mutual funds. This means that only the net of the market maker trades hit the fund and therefore the fund holders aren’t hit with unnecessary and inefficient trading. It’s also important to remember that ETF market makers tend to be some of the most sophisticated traders in the market and the basket of assets required for creation and redemptions are outsourced to these experts rather than the trading desk of the fund provider.

“I would personally much rather trust execution of multiple and global asset classes to experts rather than a less experienced and knowledgeable in-house team. On top of this, any errors made by the latter are passed onto the legacy fund holders whereas with an ETF the market makers wear that risk.

“Finally, ETFs are not super heroes. If there are underlying liquidity issues with an asset class then that will be reflected in the ETF. That’s all an ETF promises, and again that goes down to the liquidity in an ETF reflecting the underlying trading of the asset and not the traded volume of the ETF, which is often misunderstood.”

[pullquote]“When we had stress scenarios, ETFs kept trading and often represented the only window investors had to understand where prices were. When they could not touch most of their other investment tools, ETFs provided that liquidity in highly stressed markets.”

– Caroline Baron, Head of ETF Sales, EMEA, Franklin Templeton.[/pullquote]

Caroline Baron, Head of ETF Sales, EMEA, Franklin Templeton:
“ETFs have grown in popularity over the last few years as they enable investors to get quick exposure to an asset class in a transparent, flexible and low-cost manner. ETFs only represent a fraction of the mutual fund market in Europe (less than 10%) and are a welcome addition to the investment toolbox helping investors achieve more diversification, better access to some areas of the market and a wider choice of solutions at a low-cost.

“When we had stress scenarios, ETFs kept trading and often represented the only window investors had to understand where prices were. When they could not touch most of their other investment tools, ETFs provided that liquidity in highly stressed markets, even in fixed income.

“Market makers are obliged to make a price by contract. This is one of their duties they have to fulfil so they will show on an intraday basis a bid/offer spread reflecting the liquidity conditions of the underlying market.”

Adam Laird, Head of ETF Strategy, Northern Europe, Lyxor ETF:
“ETFs have been one of the most popular investments in the last decade and have seen rapid sustained growth. So it’s right to question the stability and sustainability of ETFs. But honestly, this critique misses the mark.

“BlondeMoney’s criticism is that ETF function depends on liquidity and fully functioning markets. This isn’t just true of ETFs – but all investments. If a market crash results in traders withdrawing from an asset, structure or market, prices will fall. That’s not unique to ETFs, but any traded investment.

“In many ways, ETFs are better positioned than other types of investment. In Europe, ETFs benefit from trading over a dozen markets throughout the continent – scores of market makers and thousands of professional and individual investors.

“Indeed, compared to some of the other investments mentioned, ETFs are a lot safer.”

Marcus Miholich, Head of ETF Capital Markets, EMEA and APAC for State Street Global Advisors:
“SPDR ETFs are physically backed products. They have a very transparent structure, well defined investment strategy and multiple sources of liquidity in the primary and secondary markets.”

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What alarms you about the current situation in the ETF market?

Helen Thomas, BlondeMoney:
“In 2007, CDOs equated to one-fifth of the market capitalisation of the S&P 500. The ETF market, at 6 trillion, is now of a similar size. The ETF market is now just too unwieldy. The hedging process that allows the APs to provide ETFs means that their flows are dominating the market: they’re all the same way, all at the same time. The hedging is usually done automatically, so the orders hit the market in milliseconds of receiving the risk. The hedging process relies on correlation. Even Latin American equity ETFs, such as the ILF, have a 70% correlation with the S&P 500. That means you can clear 70% of the risk immediately by trading an S&P 500 future. Or, why not use the SPY ETF? Yes, ETFs are used to hedge ETFs.

“Managing all of this risk are the Delta One trading desks of banks and brokers. They can make decisions on whether to hedge the remaining 30% of that ILF flow, for example. If they choose not to, they are taking prop risk. Banks are taking on hidden leverage on the back of ETF flows. Oh, and their capital charge is lower if the risk sits on the Delta One desk, because those positions are for ‘market making purposes’.

“Hidden leverage and unpredictable liquidity are the hallmarks of every financial crisis we have ever seen.”

Hector McNeil, HANetf:
“There is a false equivalence between a CDO – opaque, highly complex, illiquid, OTC, hard to price, non-UCITS products – and ETFs that are transparent and liquid with continuous two-way markets on regulated exchanges. The continued growth and adoption of ETFs in Europe shows that the industry is providing investors with the types of exposures they want in their wrapper of choice. Far from being ‘unwieldy’, the European ETF market is just ~€660 billion out of the total European fund asset base of ~€9.6 trillion (according to EFAMA).

“It should also be noted that the majority of ETF market making is market neutral and hedged. Yes – correlations are key, but the flaw here is that market makers are usually long short ETFs and short long their hedge, which is the opposite side of their position. They flatten those positions when they create and redeem. Creation = short ETF long hedge, Redeem = long ETF short hedge.

“ETFs are also predominately backed physically with the underlying assets e.g. S&P 500, FTSE 100 stocks. That means ETFs act like buckets, which are filled up by these assets. $6tn. It’s a fair statement to say that the demand is for the underlying asset and if ETFs didn’t exist those assets would be held in mutual funds, equities, futures and so on. ETFs therefore are a simple way to hold and manage the assets and to equate a comparison with CDOs is crude and scaremongering. The only ETFs to compare with CDOs are ETFs that track CDOs.”

Caroline Baron, Franklin Templeton:
“We strongly believe that ETFs are a great and simple tool empowering investors to allocate money in a very efficient way.

“The alarms we see are more around where we potentially are with valuations and the fact that ETFs may be the first tools that investors liquidate in case of stress (because they are liquid!). ETFs may then be associated with a market collapse when they are just enabling investors to access liquidity.

[pullquote]“There’s a gulf of differences between CDOs and ETFs – any comparisons on liquidity just don’t make sense.”

– Adam Laird, Head of ETF Strategy, Northern Europe, at Lyxor ETF.[/pullquote]

“The network of liquidity providers has extended over the last years and we are far from the model of just having a few investment banks providing liquidity. There are many more firms playing that role which in turn help investors achieve the best price.”

Adam Laird, Lyxor ETF:
“There’s a gulf of differences between CDOs and ETFs – any comparisons on liquidity just don’t make sense.”

Marcus Miholich, State Street Global Advisors:
“The argument that ETFs and ETF flows have become so big that they are “distorting” the market also does not hold water.”

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How do you see markets unfolding down the track if things don’t change with ETFs?

Helen Thomas, BlondeMoney:
“So ETFs depend upon functional liquid markets.  We are now at a turning point when central banks are turning off the Perma-QE taps. Liquidity, having been pumped in, is being sucked out. The virtuous circle where QE drove money into passive investments which compressed credit spreads, lowered volatility, and led money back into risky assets – that’s about to turn into a vicious one. We have already seen the tremors. The “Volmageddon” of February has set the process in motion. Volatility begets volatility as it feeds into risk models of long-term money managers as well as option delta hedgers. We are seeing drive-bys in market after market: Facebook, Russia, Argentina, Turkey, and now Italy. Everyone has to adjust their exposure to risk. Which changes the price of risky assets. Which is used to calculate risk. And so on.

“There are no macro narratives now, only the unwind of an unstable market structure.”

Hector McNeil, HANetf:
“Even if this is true, what does this have to do with ETFs? They are just funds and if ETFs didn’t exist and everyone still invested in mutual funds, would this point be any different? In times of volatility, it’s critical for investors to have a wide range of tools to hedge and reposition their portfolios. As liquid, transparent and tradable assets, ETFs are an ideal choice for investors who need agility. I’d rather have a FTSE 100 ETF than a FTSE 100 mutual fund when markets are moving. For example, the day after the Brexit vote, the UK equity market fell heavily and there was about 4x more ETF trading activity than usual on London Stock Exchange. Despite a falling market, despite a crowded trade and despite unusually high trading volumes, the ETF market functioned as it should and investors were able to hedge or execute their trades quickly and without incident.

“The shock absorber of ETFs’ creations and redemptions only being the net of all the buys and sells is also an important benefit in volatile markets. It means that not all investors’ buys and sells hit the fund and therefore dampens the entry and exit of the underlying assets into the market. This is a massive benefit compared to most other asset management vehicles. Will this mean it will prevent a crash? Of course not, but it brings efficiencies, cost savings and transparency to all investors not just the professional ones.”

Caroline Baron, Franklin Templeton:
“The regulatory regime under which ETFs operate is a very strong one. We had several market scenarios (2007/2008, 2011, 2015, lately at the beginning of 2018) putting the tool to the test with success.

“Of course we never know what is coming next but ETF providers and their ecosystem partners closely work together and with the regulators to ensure robustness.

“ETFs have responded very well so far and are doing what they are supposed to be doing. If market conditions were to change dramatically and liquidity were to dry up, ETFs would paint that picture as they are only as liquid as their underlying.

“As the world keeps moving, there might be more opportunities to generate alpha and this is where investors need to have the agility to use their investment toolbox according to their views and to the market conditions.”

Adam Laird, Lyxor ETF:
“I won’t say liquidity is no concern for ETFs. ETFs have opened the door for a lot of previously illiquid or inaccessible assets. If you’re buying a niche corner of the bond market, liquidity might be thin. You might get lucky buying an ETF, but particularly when markets are stressed, there’s no guarantee.

“Any hedge fund consultant is aware of the dangers of liquidity. In recent years we’ve seen junk bond and property funds shutter under market stresses. But we’ve been fortunate that ETFs have never seen these sort of persistent liquidity shocks. ETFs depend upon functional liquid markets; in Europe at least this system works.”

[pullquote]“It is important to understand that an ETF is as liquid as its underlying basket.”

– Marcus Miholich, Head of ETF Capital Markets, EMEA and APAC for State Street Global Advisors.[/pullquote]Marcus Miholich, State Street Global Advisors:
“It is important to understand that an ETF is as liquid as its underlying basket due to the dual execution routes. So if there was a distortion in price, investors could trade the underlying basket instead and use that arbitrage to make money, but ETFs trade at fair value so the distortion does not exist.”

Hector McNeil, HANetf:
“Finally, it’s clear where people scaremonger and try to create unfounded fears, it usually mean they are conflicted in some way and try to cast a cloud or confusion rather than fixing issues and inefficiencies that are relevant in their own business models. ETFs may not be perfect but they have certainly shone a light on an industry that felt no shame in charging the earth and ignoring what investors truly need to optimise their investments and savings.”