US investment manager Michael Burry, of “Big Short” fame, has had a lot of coverage over the past week after he said exchange traded funds (ETFs) were the next great asset bubble. He compared the growth in index ETFs to the collateralised debt obligation bubble that sparked the financial crisis in 2008.
Burry is worth listening to. He shorted CDOs pre-CGC and was one of the few big winners in the financial crisis. But should we be selling our ETFs?
The first thing to note is that similar comments to Burry’s have been made by other commentators a number of times over the past 10 years, as the ETF market has grown. The second is that some of his criticism is directed at ETF products that are not common in the local market – synthetic and inverse ETFs.
The concern is that these funds, which might have funds under management of billions of dollars, are being traded on an intra-day basis to capitalise on short-term index changes. They are magnifying volatility and they are putting a lot of people’s savings at risk.
But third, regulators also have their concerns about ETFs and they think it is important for investors to understand the securities they are investing in and the risks they are taking. It is probably a case of being alert not alarmed.
Back in 2011 BetaShares modified the investment strategy of two of its ETFs. The two funds had used derivatives (equity swaps) in their structures and were classified by the ASX as “synthetic” ETFs. Following the modifications BetaShares S&P/ASX 200 Financial Sector ETF and BetaShares S&P/ASX 200 Resources Sector ETF used investment strategies based on conventional, physical stock index replication.
Synthetic ETFs were in the news at the time, with some commentators arguing that exchange traded funds were the latest toxic investment to plague world markets. The Australian Financial Review reproduced an article from the New York Times, headed: “ETFs are new weapons of mass destruction”.
What the ASX pointed out at the time was that with almost all index ETF on the local market, index replication was done physically. This involves buying a basket of stocks that will provide a return that is close to the index return. It is still much the same today.
Burry’s comments last week were directed at synthetic ETFs but also at inverse ETFs, such as so-called “bear” funds that short an index.
BetaShares has three bear funds in the market currently. The company’s chief executive Alex Vynokur told the Australian Financial Review on the weekend that local ETF issuers had learned some lessons from overseas experience. BetaShares backs its inverse funds with cash and cash equivalents to avoid exposure to counterparty risk.
While Burry’s criticisms may not have direct application to the local market, there are still some issues. In July, The Australian Securities and Investments Commission confirmed that it had notified the ASX and other exchange market operators that it does not want them to admit certain types of funds, while it reviews the exchange traded fund sector.
The types of funds it does not want listed are actively managed funds that do not disclose their portfolio holdings daily and have internal market makers.
ASIC says internal market making occurs when a managed fund’s responsible entity acts as the market maker for its own fund on the fund’s behalf, either by submitting bids and offers itself or by engaging a transaction agent that executes its instructions.
ASIC estimates that internal market making funds represent about 6 per cent of exchange traded products by funds under management.
Over the past year ASIC has expressed concern about a shortage of market makers locally. It is also concerned about transparency, liquidity, volatile trading spreads and what it sees as a lack of retail investor understanding of the product.
The regulator is conducting a review of the sector, which it says will run for the rest of the year. It says it intends to review the regulatory settings for exchange traded managed funds that use internal market makers.
In a review of the local ETF market last year, the ASIC said the market was “generally functioning well” and was delivering on promises to investors.
However, it detected some potential risks that require monitoring by issuers and oversight by market operators. It wants issuers to do more to inform investors about the tracking error of funds, indicative net asset values and trading spreads.
And it said it was concerned that there too few market markers providing liquidity in the local ETF market.
ASIC says: “ETF trading is generally liquid, bid-offer spreads are narrow and secondary market prices are generally close to the NAV is ETF units. However, this does not necessarily apply to all products at all times.”
“In particular, we observed that spreads do temporarily widen in some circumstances, meaning individual transactions may involve a higher spread than an investor may consider desirable. The spread may significantly affect investor return.”
The International Organisation of Securities Commissions is currently doing a study of the ETF product.
Robert Taylor, chair of the committee on investment management at IOSCO, says the study is focusing on how much investors understand about the way ETFs work, the role of authorised participants and market makers, the relationship between the product issuer and the investor, and the increasing complexity of the product.
Speaking at a Financial Services Council conference earlier this year, Taylor said: “Things start with simple variations. Then they get more and more complex. We saw this with structured products pre-GFC. Banks ended up having to pay back a lot of capital because customers did not fully understand wat they were getting into.
“Regulators are interested in making sure we do better than we did with structured products.”
He says that since the GFC regulators have taken a more forward-looking approach to their work, spending a lot of time looking at what the risks could be. One question he asks himself is how ETFs would have performed in 2008.
“People in the industry often don’t see the risks emerging,” he says.
“There is a belief in the liquidity of the product and a belief that this product is better and more efficient. But when you talk to retail investors, it is not clear what they think they are buying. They don’t understand the basic arbitrage functions that supports it.”
ASIC also wants ETF issuers to have policies for dealing with ETFs that are too small to be viable or are otherwise unsuccessful. It is encouraging issuers and market operators to develop policies for dealing with unsuccessful funds, such as funds that are too small to be economic.
Last October, funds researcher Zenith Investment Partners issued a report saying that up to half of the ETFs listed on the ASX may be too small to be viable.
Zenith says that while the local ETF industry has grown strongly, it is dominated by a small number of large funds. The top 10 ETFs by size make up close to 50 per cent of the sector’s market capitalisation and the top 25 account for 70 per cent of total market cap.
“While the exact level of funds under management at which an ETF is profitable depends on a variety of factors around the asset class in which the ETF operates, as well as the manager’s infrastructure, scale of the product suite and fee level, most ETFs should be profitable at between $50 million and $100 million,” Zenith says.