Opportunities and Challenges of ETFs in Asia Pacific: Should We Worry about Systemic Risks?

Speakers: Simon Brailey, Deborah A. Fuhr, Anil Ghelani CFA, Piotr Zembrowski CFA
Contributed by: Jolly Balva CFA, Member, Research and Advocacy Committee, CFA Society India

 

The Role of ETFs in Today’s Markets:
  • ETFs provide well-diversified, low-cost portfolios
  • ETFs eliminate the idiosyncratic factor, leaving only the systemic factor
  • ETFs provide access to difficult markets and assets
  • With a variety of ETFs available, they have become building blocks of active portfolios
Below are the Major Concerns Related to ETFs Globally: 

ETFs Amplify Market Movement ETFs have grown to hold much power. Passive funds own more than half of US equities. They appear to amplify market movements during periods of stress and uncertainty, reflecting the impact of feedback trading from ETF markets to the underlying markets and vice versa. For instance, in 2013 during the ‘taper tantrum’, outflows from bond ETFs exacerbated bond yield spreads. Market herding leads to information efficiency in prices (between NAVs of ETFs and underlying markets) decreasing.

ETFs Exacerbate End of Day Volatility APs tend to rebalance their portfolio in order to minimize their tracking error. End of the day trading has increased with increase in volumes.

Authorised Participants may ‘Step Away’ There are usually a handful of APs that are active in ETFs. They keep the ETF price in line with NAV through arbitrage. They have no obligation to create or redeem ETF units and are not compensated for it by the issuer. There is some evidence that they scale back activity in stressful periods. This is especially serious in illiquid markets, where APs are often also the dealers in underlying markets.

Rebalancing Risk ETFs based on illiquid, non-transparent markets can face rebalancing risks, which can lead to systemic effects on both the ETF and the underlying.

Effects Spread to Other Markets The use of ETFs as cash substitutes by money market funds and other investment products raises the prospect of problems in ETFs spreading to other markets.

High Concentration There is high market concentration as there are 2-3 big issuers in each category. There is also high ownership concentration in some markets, for instance BoJ owns 80% of Japan’s ETFs.

Large Short Interest as hedge funds short-sell ETFs as part of ‘long stock – short industry’ strategies,zeroing in the idiosyncratic factor, while cancelling the idiosyncratic factor.

Structure and Constraints in APAC

APAC ETF market is growing by 25% CAGR, with a size of $1T and is dominated by Institutions. BoJ owns 80% of ETF market, Insurance in Taiwan and Pension funds are big in india. Number of constraints are fundamentally different from other markets and are holding back further growth of ETFs.

  1. In most APAC markets, it is an intermediated, commission based fund distribution model. Because ETFs don’t pay commission to intermediaries, they tend to be dominated by mutual funds. Other markets have moved to a fee-based distribution of ETFs.
  2. Second issue is lack of liquidity. Secondary market liquidity in US, Europe is deeper. Because of the intermediated structure and limited retail usage, it is difficult to achieve scale in APAC.
  3. Third is lack of tax incentives. ETFs in US have significant tax benefits.
Recommendations
  • Review circuit breakers and trading halts for ETFs
  • Examine market closing mechanisms and restrictions
  • Closely monitor AP activity. Estimate ‘step away’ risk.
  • Reconsider the dissemination of intraday NAV
  • Re-evaluate liquidity rules for ETFs
  • Understanding the extent of ETF use as a cash substitute
  • Improve dissemination of information on underlying markets where ETF trading is significant
  • Consider restrictions on creation and redemption of units during periods of uncertainty
Questions and answers

Q: How can regulators promote or stifle the growth of ETFs?

MIFID in Europe and similar regulation in UK and Australia have helped the move to fee based model and has driven growth. Growing awareness and innovation will also help.


Q:
Exercising of shareholder rights by ETF managers

There are 474 issuers of ETFs. Larger firms are looking at governance and other topics to vote across ETFs, especially as the world is moving into sustainable investing.


Q:
Are the concerns of systemic risks relevant to the same extent in APAC?

Data doesn’t prove they are same in entirety. In Q4 2018, 25% of the assets were redeemed in four days. Bonds held in ETFs and not in ETFs, there was minimal difference in bid-ask spreads. Another study which looked at the ratio of secondary vs primary market activity  over multiple cyles, and during the times of stress the volatility increased but the underlying market was not impacted. The reason is that the secondary market acts as a buffer, which doesn’t happen in MFs.


Q:
What are the advantages of ETFs vs index funds?

For certain set of investors, ETFs are better viz. corporates and if you want to hedge. But if you are a retail investor, index fund is better because you don’t have to bother about liquidity etc. For Index funds you need a demat account, whereas not required for ETFs.


Q:
What are the possible systemic risks in a growing market for ETFs?

Develop the entire eco-system. Market makers, broking system, index providers need to be in place. Otherwise it will be difficult to see the scale up happening.


Q:
Will ETF issuers be predominantly large issuers ?

Although it is concentrated amongst a few players, there are mid and smaller sized firms coming up with good ideas and launching products. The trend will continue.


Q:
Do you think that ETFs would contribute to a financial bubble?

It’s a wrapper of creation and redemption of units on a daily basis. They should have enough to provide for liquidity. Considering that Small cap tends to be less liquid for instance, one has to think carefully about their suitability for such products

 


Recorded Webinar Link:

https://www.arx.cfa/en/research/2020/09/soc210920-webinar-etfs-asia-pacific-systemic-risk?

 



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