Exchange-traded funds: a timebomb likely to blow up?

Since their creation in the early 1990s, exchange-traded funds, or ETFs, have found favour with many an investor looking to gain exposure to a particular index or benchmark at a lower cost than a similar actively managed fund.

However, in recent months the shine of an ETF has appeared to tarnish, with industry heavy-weights such as Blackrock's Larry Fink arguing that structural problems associated with the product have the potential to "blow up the whole industry one day".

He's not the first to point a finger at leveraged ETFs, but when Fink, head of the world's largest investment fund – and ETF manager through its iShares operation – asserted that ETFs could be dangerous and could pose a systemic risk, the world listened. But what are the risks inherent in a leveraged ETF and should Irish investors be concerned?

What is an ETF?

When they were first created, ETFs primarily offered investors low-cost access to a variety of indices such as the S&P 500, FTSE 100 and Nasdaq 100.

Unlike a typical actively managed mutual fund which might be trying to beat the market, such as the aforementioned S&P 500, an ETF tries to reflect the market by acquiring the underlying securities in the index it tracks.

Traded like shares, ETFs are quoted on a stock exchange and offer the benefit to investors of broad diversification – at a lower cost. Such a structure has allowed Irish investors to swap an actively managed US fund, which was basically tracking the S&P 500 but charging 1 per cent to do so, for an ETF, which may have annual charges of as little as 0.2 per cent (excluding brokerage fees).

So an investment of €50,000 in an ETF would have returned €2,200 more over five years, based on an annual return of 5 per cent and the lower fees and charges.

And, as they are traded on the stock market like a share, a world of investment opportunity also opened up for Irish-based investors, allowing them to invest in ETFs tracking everything from emerging market corporate bonds to infrastructure funds.

"ETFs have been a very successful product. There is nothing wrong with an ETF instrument itself; it's a structure that you can passively manage and track equity exposure for your fund," says Ian Huggard, head of Irish equity sales at Investec Bank.

Globally, the ETF market is worth about $2.5 trillion, with BlackRock’s iShares ETFs range taking a 39 per cent share of the global ETF market, followed by State Street and Vanguard.

Leveraged ETFs Where problems might arise however, is with the leveraged equivalent to an ETF. Introduced by product providers in recent years, these work by using derivatives and debt in order to try and boost returns, and they are typically offered on a long (bull) and short (bear) basis.

And, in a yield-hungry environment, leveraged ETFs have gained in popularity with both private and institutional investors, ramping up the risk and potential returns as well as the amount of money coming into the sector – in the first four months of 2014 alone, leveraged ETFs attracted $1.8 billion.

Huggard likens leveraged ETFs to the contracts-for-difference (CFDs) which were once upon a time so popular with Irish investors.

Back in the naughties, Irish private investors – not always with cash to spare – ploughed aggressively into CFDs, with leverage of about 10 times their original investment.

When the markets collapsed, many found themselves on the wrong side of these deals, a situation which was worsened by the fact that they may have only put up a certain proportion of the initial capital, and were also faced with cash calls.

Leveraged ETFs work in a similar way, in that they accentuate any upside gain – but the downside may also be a multiple of the direction in which the market in which you are invested has moved.

While such a risky approach can pay off for investors, if the underlying securities or indices drop then the losses can also turn into a multiple of what they otherwise might be.

“If the index goes down by 2 per cent, a vehicle that is leveraged by four times will equate to an 8 per cent loss. Conversely if it goes up 2 per cent you gain 8 per cent,” says Huggard, noting that the impact of leverage may differ slightly according to the fund’s strategy.

Another example is the Direxion Daily S&P 500 Bull 3x Shares ETF.

Last year, when the S&P 500 rose by 32 per cent, it gained 118.9 per cent, or nearly quadruple the S&P 500’s gains.

However, while such leverage can pose danger, leveraged ETFs do differ from their CFD predecessors in that investors typically put 100 per cent of their investment into such a product – thus the added risk of margin calls may not be a factor.

Recent

furore Speaking in New York last month, Blackrock’s Fink highlighted the risk this level of leverage – in a world in which leverage from the last crisis has yet to be fully unwound – might pose.

“We would never do a leveraged ETF. We just think that’s just a structural problem that could blow up the whole industry one day, “ he said.

Fink also drew parallels between the embedded leverage in ETFs and the subprime meltdown, noting that if the value of some ETFs collapse because their underlying securities – such as leveraged bank loans – become too hard to trade, it could see investors flee ETFs, thus posing a systemic risk.

Leveraged ETF providers have struck out against Fink’s comments.

Direxion Investments, which has about $21.9 billion in gross leveraged ETF assets (equating to gross notional exposure of about €50 billion, given the leverage), argues that a critical element of ETFs is that they rebalance on a daily basis.

“From a systemic risk perspective, this is textbook risk management behaviour, and means that counterparties which provide balance sheets to the products never see leverage ratios increase,” it argues.

Another argument is that the scale of leveraged ETFs is not as significant as might be feared – total leveraged ETF assets for example represent about 1.5 per cent of the $2.5 trillion in global ETF assets under management.

One of the largest leveraged ETFs on the market for example is the ProShares UltraShort 20+ Year Treasury, which seeks a return of two times the inverse (-2x) of the daily performance of the Barclays U.S. 20+ Year Treasury Bond Index. It has about $4 billion in assets. Contrast this with the SPDR S&P 500 ETF from State Street, which has about $167 million in assets.

Indeed Deborah Fuhr, managing partner with ETFGI in London, argues that "as the size of these products is so small, they do not pose a risk to the financial industry".

Irish

concerns So perhaps the issue then is whether or not investors should be taking on leverage – and whether or not they fully understand it.

"I don't think anyone should leverage their savings. The purpose of making savings is that you salt it away. When you put leverage in, you increase the risk," says Brian Weber, head of Quilter's Irish operation. "I don't believe private clients should use leveraged instruments, period."

For Huggard it comes down to, “when you buy it do you understand leverage? In an Irish context, it transpired that people didn’t understand CFDs. It’s probably fair to say that people don’t understand leveraged ETFs either.”

Indeed one Irish financial adviser who delved into leveraged ETFs on behalf of a client who had purchased one, found that it didn’t track the market as expected, with the losses appearing to be more exaggerated on the downside.

This may be because that such products deleverage when markets fall, but only incrementally increase leverage thereafter. “My view is not that leverage is good or bad; my view is that intermediaries need to understand what it is they are proposing for their clients, and the regulator needs to ensure that intermediaries are explaining them correctly to investors,” says Huggard.