Exchange-traded fund (ETF) assets have grown rapidly from $100 billion in the early 1990s to almost $3 trillion today. Last year, they made up four of the five most actively traded securities, according to Strategas. Fad-like offerings are increasingly coming to market with cheeky tickers such as “SHAG”. Even celebrities like Quincy Jones have attempted to capitalize on this trend. Some are now worried that an ETF bubble exists, which will eventually burst and undermine the stability of the financial system.
Despite their increasing popularity, many still misunderstand what ETFs are and how they work. At Balentine, we deploy ETFs to implement certain exposures, and in response to several client inquiries, this post addresses some common misunderstandings about ETFs.
What is an ETF?
Essentially, an ETF is a security traded on an exchange which seeks to replicate the behavior of a diversified basket of underlying assets, such as stocks, bonds, or commodities. Large broker dealers, called authorized participants (APs), act as market makers (MMs) and create or redeem units in exchange for the underlying securities to provide liquidity to ETF markets. So, unlike mutual funds which are priced once at the end of the day, ETFs offer continuous pricing throughout the trading day around their underlying net asset value (NAV). In addition to superior liquidity, ETFs offer greater tax efficiency and typically have lower transaction costs than mutual funds.
Four concerns are often raised about ETFs
Concern #1: ETFs are structurally flawed and cause stress in financial markets.
ETF prices reflect the prices of their underlying ingredients. So, for example, if the spreads of stocks widen, the spreads of ETFs can be expected to widen, too. Unfortunately, this relationship often means that ETFs are accused of causing a break down in the functioning of markets when other, deeper reasons are at play. Two recent examples illustrate this point.
A widely cited case of ETF price dislocation is the morning of August 24, 2015, when more than one-fifth of U.S.-listed ETFs from an array of providers halted trading in the minutes directly following the opening bell. Though ETFs took much of the blame, the pricing discrepancies were not an ETF issue, but rather a byproduct of structural problems within the U.S. equity market, specifically the obscure New York Stock Exchange (NYSE) Rule 48. Rule 48 is intended to speed the opening of markets when a volatile trading session is imminent, reducing designated market maker duties, such as showing pre-opening pricing indications, and allowing the opening of stocks on a case-by-case basis. On that day, nearly half of the stocks listed on the NYSE were not trading 10 minutes into the session. Bid-ask spreads subsequently widened as traders became reluctant to fill orders on a lack of pricing information.
Another culpable party was the “limit-up, limit-down” rules. The “Clearly Erroneous Trade” policy, enacted after the 2010 Flash Crash, halted trading for five minutes in securities once they exceeded a certain depreciation threshold. The rules had the unintended effect of halting trading once ETF prices decoupled and declined, impeding reversion to the true valuation once market participants stepped in to raise prices. There were examples of ETFs decoupling from indices for as many as thirteen minutes, but for roughly ten minutes, trading in these shares was halted.
More recently, on March 20, 2017, the electronic exchange NYSE Arca experienced problems with its closing auction in which several of its ETF listings failed to price at the close, affecting $150B in ETFs. The glitch was promptly attributed to a botched software rollout and remedied that evening. Again, ETFs were implicated in the turmoil even though they were not the true cause of the end-of-day scramble.
Balentine sets strict price limits when trading ETFs to mitigate against such potential disruptions, rare as they may be.
Concern #2: ETFs are derivatives.
Following the 2008 financial crisis, derivatives fell sharply out of favor as investors shied away from anything resembling financial engineering. A key distinction between exchange-traded funds and financial engineering is the asset-backed nature of the ETF. That is, when purchasing an ETF, an investor is purchasing shares backed by the underlying assets.
There are two caveats to this general rule: leveraged ETFs and exchange-traded notes (ETNs). Leveraged ETFs aim to magnify expected returns from the underlying basket of securities by borrowing money and, therefore, could be classified as derivatives. ETNs are a form of senior unsecured debt issued by a bank with repayment of principal backed by the creditworthiness of the issuer. If the underwriter were to experience a credit rating downgrade, for example, the value of the ETN would likely take a hit even if the index it is tracking is entirely uncorrelated. With an ETF, in the event of asset manager default or even bankruptcy, the investor’s assets are safe from creditors.
Concern #3: ETFs are a passive investment strategy.
ETFs often use passively managed strategies to select the underlying basket of securities they seek to replicate. They have become so intertwined that investors assume ETFs and passive investing are one and the same. However, just like a mutual fund, an ETF is simply the investment vehicle and the mechanism through which buying an index is made available.
Though the majority of ETFs follow a passive mandate, a few ETFs ( approximately 190) employ active management. At Balentine, we tend to favor passive strategies for public market bond and stock exposure, although we do use active management from time to time. Even with passive management, there are many factors to take into account, which is why we at Balentine believe that passive management requires active due diligence!
Concern #4: ETF prices do not always reflect intrinsic value accurately.
Unlike mutual funds, which strike a net asset value (NAV) once at the end of the day, ETFs trade throughout the day and run the risk of not reflecting the true value of the underlying securities. ETFs that offer exposure to international securities are especially vulnerable to this—for example, an investor trades a Japanese stock market ETF on the NYSE when the underlying local markets in Japan are closed. Exchanges have sought to mitigate this risk by calculating and disseminating an ETF’s intraday net asset value (iNAV) throughout the day. However, prices may still reflect significant premiums or discounts to published iNAVs if the market arrives at an estimation of fair value that is different from the assumptions that exchanges used to calculate them. Ultimately, the best way to mitigate this risk remains to trade an international ETF while underlying local markets are open, as we typically seek to do at Balentine.
While it is important to acknowledge and address these common concerns about ETFs, it is also worth highlighting the reasons for their rapid growth. ETFs offer investors a cheap, liquid, and transparent way of obtaining exposure to a basket of securities; yet their role in aiding price discovery and enhancing liquidity for market-making firms, especially in fixed income asset classes, is often overlooked.
ETFs aid in price discovery and liquidity enhancement
Unlike stocks, bonds are traded in the over-the-counter market and can go days or even weeks without trading. In 2016, 56% of investment grade issues and 62% of high-yield bonds traded fewer than 16 days per month. Because ETFs trade much more frequently, the ETF price can actually better reflect the intrinsic value of a basket of underlying bonds, and many systems have been developed to help facilitate this price discovery.
As post-financial crisis regulation has forced banks and other liquidity providers to hold more capital on their books, traditional suppliers of market liquidity can no longer extend capital to trading. In 2008, banks held roughly $250B in bond inventory globally; by December 2016, this number had fallen to less than $50B. ETFs allow for (some) disintermediation of trading activity and connect investors directly on exchange while reducing the need for principal trading directly with a broker.
By incorporating the bonds into a tradeable, liquid basket, ETFs add liquidity to the fixed income ecosystem and remove the need to transact in an illiquid, over-the-counter market. A frequently cited metric of security liquidity known as the bid-ask spread lends some credit to this fact. Often, this spread is tighter for the ETF than the spread of the underlying basket, translating to lower transaction costs for the investor.
For all these reasons, we think it is misguided to label the rapid growth of ETFs as a “bubble” that is about to burst and undermine the financial system. As investors become more aware of what ETFs are and how they work, they will become as accepted as mutual funds are today. ETFs are simply another mechanism by which people gain exposure to investment strategies, but, as with mutual funds, investors must pay attention to mitigating their potential risks while capitalizing on the advantages they offer.
Please do not hesitate to contact Balentine with questions about ETFs or other investments.
 Intraday Net Asset Value = the current market value of the underlying assets divided by the number of shares outstanding.
 Bid-ask spread = the difference between what a seller is willing to accept for a security and what a buyer is willing to pay for that security.