Risks associated with exchange traded funds may increase as the fast-growing market continues to expand and develop more “novel” investment structures, the Reserve Bank has cautioned.
According to an analysis of the Australian ETF market in the latest Reserve Bank Bulletin, a number of concerns and potential risks have been raised by market participants and regulators.
The report also points out that ETFs have underperformed their benchmarks.
Concerns include liquidity risk, counterparty and collateral risks and the complexity of some structures.
Liquidity could decrease in times of market stress, particularly if market makers withdraw from the market.
There has been an increase in the number of ETFs with more complex structures – known as “smart beta” funds – and synthetic ETFs involving derivatives.
The ASX has more stringent admission requirement for ETFs than apply in other markets and this has limited the scope of synthetic ETFs.
ETFs are investment funds that are traded on a securities exchange and, in most cases, track a specified benchmark index. Typically the benchmarks are equity indexes but ETFs also track fixed income, cash, commodity and currency indexes.
They provide exposure to a market at low cost and with the promise of liquidity.
An important group of participants are the market makers. In Australia, ETFs are required to have one primary market maker, which is obliged to show quotes for buying and selling ETF units.
The local ETF market has tripled since 2012, to around $25 billion. There are more than 130 ETFs traded on the Australian Securities Exchange and turnover is around $60 million a day.
They account for about 1.5 per cent of local stock market capitalisation, compared with about five per cent in Canada and Europe, and about 10 per cent in the United States.
In Australia, domestic equity ETFs account for the biggest share of the market, at 44 per cent of the value of all ETF issuance. International equity ETFs make up about 40 per cent of the market and domestic fixed income and cash ETFs make up about 11 per cent.
One measure of the performance of an ETF is how well it tracks its benchmark. Over the past year Australian listed ETFs underperformed their benchmarks by around 1.5 percentage points on the basis of annual total return.
Most of that variation can be accounted for by fees, transaction costs and index licensing costs.
Also, an ETF might only hold a representative sample of the index due to costs or difficulties associated with holding some of the securities in the index. This may create some divergence.
The size of an ETF can also affect returns. Some small ETFs are lightly traded, so a significant amount of time can elapse between the last ETF trade of the day and the end of the trading day, when benchmark returns are calculated.