With asset owners increasingly looking at tactical investing, understanding the impact of financial innovation on market volatility is more important – and simultaneously more challenging – than it has been in the past, a group of high-level investment experts have said.
Given the rich valuations, asset owners are constantly scouring the market for opportunities. Investing in innovation through fixed income ETFs is one approach to exploiting market inefficiencies. ETFs now account for US$5.2 trillion of assets globally.
There is no doubt that ETFs have been advantageous in increasing access adding liquidity, simplifying investment implementation and reducing costs. But it is the market friction underneath the ETFs that some investors believe has led to high volatility, subsequent fund outflows and ultimate drawdowns in recent months.
Despite their popularity, investors face challenges when implementing ETFs because of the market friction – primarily the mismatch in the liquidity of the ETF and the underlying assets – said participants at the recent State Street sponsored Investment Magazine roundtable “The impact of financial innovations and global market inefficiencies”.
Facilitator Alex Proimos, Conexus Financial’s head of institutional content, domestic events, questioned participants on what was preventing them from applying ETF strategies and whether the need for underlying liquidity had become a hot button issue.
Nader Naeimi, head of dynamic markets at AMP Capital Investors, certainly sees liquidity as a key concern.
As he sees it, the problem is that an ETF’s underlying asset could be totally illiquid yet the ETF could trade daily.
The weight of money now invested in these products has further fueled concerns that if the big investors all bail out of an ETF at the same time, the chances of investors dumping the underlying security will rise, which, in turn, could impact financial stability. Retail investors, particularly, are more sensitive to change and likely to withdraw money.
Financial regulators are increasingly focused on the potential threat of ETFs as they become more widespread among institutional assets owners and retail investors. Fears of a failure in the marketmaking activity that underpins the instrument are building.
Global watchdogs worry about the disconnect between the price of an ETF and the underlying asset that sits beneath it. They regard it as a problem.
The role of diversity
One of the ways to solve the volatility problems, and prevent black swan events is having a diverse group market participants to help clear the market.
During the roundtable discussion, Geoff Warren, associate professor at Australia National University asked whether there was any evidence that new passive instruments like ETFs actually weakened market diversity. Warren, who is also convenor of the ANU Student Managed Fund, argued that when the market loses diversity it becomes unstable.
“When you have a massive amount of fund flow going into a particular product, he said, then that fund flow ultimately drives price,” he said.
“The result can be less market diversity as all the participants are on the same side of the trade. “When everyone trades in the same direction on the way up, it looks rosy. Returns get hammered when you have outflows – you could be in the situation of a forced sell and there is no one on the other side.”
The potential for the market to have correlated flows that put pressure on the market as occurred during the quant crash of 2007 – when quantitative equity strategies suffered losses – was flagged by several participants as an example of what can happen with forced sales.
Another example is the flash crash of August 2015 which caused a number of ETFs to stop trading in the US. John Lucey, CIO of Avant Group pointed out that this pressure is consistent across all asset classes when there a lack of diversity in markets. “Funds face that kind of pressure when the market moves one way regardless of what asset class or instruments they’re invested in.”
Intense Scrutiny
Rory Tobin, the global head of ETFs at State Street Global Advisors, pointed out that global regulators don’t want “the next accident in financial services to come from the ETF industry”.
Tobin told participants he spends hours with regulators talking about the liquidity issue – more particularly on the underlying liquidity of bonds since State Street sells bond-linked ETFs.
What’s interesting for the State Street chief is the US is seeing the evolution of fixed income as an asset class and the pace of adoption of bond-linked ETFs is growing rapidly.
In fact, global inflows in the first two months of 2019 for bond-linked ETFs have exceeded those for equity ETFs and are headed towards the US$1 trillion mark.
Importantly, Tobin went on to say, trading volume in times of crisis is in the ETF unit itself and very little takes place in the underlying basket.
“So the strain of the market event – the buy and sell event – is being absorbed by the trading in the exchange.”
Regulatory reforms have forced banks to drop their inventories and that led to liquidity challenges in the bond market, which bond-linked ETFs are helping to adjust.
Accordingly, regulators are conscious that buying the index and replicating index performance is much harder than it once was because access to bonds is limited. “The most important providers of liquidity in fixed income markets are backing away from provision of liquidity,” Tobin said.
Bond exposure
Consequently, in Tobin’s view, fixed income ETFs have provided investors with a way of getting exposure to bonds. As a result, he argued, creating fixed income portfolios with individual bonds has become more expensive and less efficient than in the past, encouraging investors to switch to fixed income ETFs.
He agreed with the roundtable that investors should never expect that the ETF will be more liquid than the underlying basket of securities.
However, he pointed out that with the rapid growth of ETFs, the bid/ ask spread on the unit trading on the exchange secondary market is tighter than the underlying basket of securities.
In other words, the mismatch between ETF and the underlying assets doesn’t happen in the large bond issuers. “That has emerged most acutely with large bond-linked ETFs,” said Tobin, referring to the tight bid/ask spread.
His comment was directed to ,Jana senior consultant David Surridge, who warned that fixed income ETFs were notoriously illiquid and dangerous as funds in the credit space don’t have the option of buying a derivative.
The roundtable discussion turned to the idea of ETFs being financial instruments in their own right. Further, while some asset owners may take a buy and hold position, others have cash flow requirements and use ETFs for the management of the cash sleeve.
Tactical investing
Different investors have different timing horizons – so they have a different approach to the optimisation of cost, risk and return.
“So if someone is looking for tactical asset allocation purposes and someone is making some tactical trades and switches they will look at the most liquid instrument they can trade the most effectively at the cheapest cost,” said Tobin.
On tactical investment, Surridge argued while asset owners claim to be long-term asset allocators that’s not how they trade. He noted that they move in and out of instruments at a higher velocity than they should.
There was some discussion about the value of sector ETFs and the difficulties of finding ETFs that have been screened using environmental social and governance (ESG) criteria.
AMP Capital has used ETFs for specific exposures to themes such as energy, utilities and medical themes. As a top-down active manager, Naeimi concedes that without ETFs, the fund would have to go to a broker to create a basket. “Ten years ago, there wasn’t a sector ETF so you created a basket. Now we are spoilt for choice and ETFs allow us to create thematic portfolios from a top down perspective.”
Mercer principal, Harry Liem underlined the dearth of ETFs with an ESG focus. Liem said there were a few, but not many ETFs with a sustainability theme. ANU has a Socially Responsible Investment policy and in Warren’s view the recent ETFs with an ESG focus have failed.
This is a big issue for him. “What’s available are ETFs with a Socially Responsible Investment strategy rather than SRI that represent a particular asset class,” he added.
Costs were also a significant part of the discussion with asset owners increasingly looking closely at their strategies to determine how they can get the best value. Every basis point of costs counts in the current low-yield environment which has been hard for active management. That said, ETFs are not seen to be the cheapest option.
Transaction costs are becoming an area of focus for Cameron Sinclair, portfolio manager with EISs Super who added that ASIC regulation RG97 had made life more complicated and his fund more fee-focused. The roundtable concluded that financial innovation sought to address the asset owner concerns around the mismatch in liquidity from underlying assets and product innovations such as ETFs.
