Deciphering The Burgeoning ETF Market

1_uNrJP1jT829abISDzJr_KA.jpeg

The ETF gold rush has opened up a galaxy of opportunities for investors. However, at the same time, it poses serious challenges and risks. Today, we’re going to discuss what it takes for investors to successfully navigate investing using ETFs.

The rise and rise of ETFs

For investors, ETFs have all the hallmarks of a panacea. Democratisation is the commercial mantra, opening up a plethora of previously hard to access asset classes, compressing fees, and empowering self-sufficient investors to buy and sell investment funds as if they were individual stocks. The benefits for investors are obvious and plentiful: lower costs, access to a myriad of risk, greater liquidity than fund constituents. I could go on.

ETFs account for $5.1trn in global assets, and that figure continues to grow. These funds have “disrupted” the asset management industry, both for institutions and retail investors, who now rely on them to construct risk portfolios

With greater complexity comes greater risk

The range of asset classes and risk typologies embedded in ETFs, and the creativity of issuers seeking to meet investor demands, create opacity and risk. ETFs offer more flavours and ingredients than your local gelato bar. Long/short, leverage, passive/active, distributing/ accumulating, currency hedged, physical/synthetic, index vs market cap weighted. The list goes on. And, aside from equities and fixed-income funds, there are emerging asset classes such as “Liquid Alts” and REITs. Thematic Investing has gained popularity in recent years, since investors buy into themes and narratives more than individual asset classes. Want exposure to health and wellness or gender diversity? There are ETFs for you. Financial themes such as the The return of volatility to global capital markets, the end of ECB bond buying and longevity are all macro themes currently keeping investors up at night, and also well served by ETFs.

This dizzying array of choices might sound like a good thing, but it’s a double edged sword for investors. There are dozens of Japanese Equities and liquid US high yield bond fund ETFs. Salespeople and brokers work their socks off to cover the market, but it’s nigh-on impossible for any human to remain on top of all this information. Investors are equally overwhelmed by choice.

Because of this, people lean on the plethora of websites devoted to helping investors make sense of their options. Lipper and Morningstar with their ratings methodologies have hard-earned their credibility while others clearly have not. It is difficult for investors to know if they are being ‘guided’ or being ‘brokered’. We are yet to see Amazon-style recommendations that really help users navigate the thousands of available options, but this is about to change. Machine Learning-based recommender systems, like the type employed by Spotify and Amazon will revolutionise the way investors select ETFs. At present virtually every ETF issuer and many third-party websites have tables of ETFs with filters for investors to search. In future ETFs will be automatically matched to investor interests and investment criteria. These systems will incorporate investor’s past-browsing preferences to issuer, tracking-error and leverage amongst others.

Broadly, because of the way markets have evolved, European ETFs have been designed for institutional investors, while US funds are aimed at retail. This has resulted in ETFs becoming a fragmented, non-standardised investment product.

One worrying aspect is that since risks are hard to quantify for non-markets professionals, they are rarely discussed. In the competitive world of high finance, issuers originate and distribute. They don’t obsess over risk prevention. That’s the domain of the investor. What this means is that many investors don’t understand what they are getting exposure to. That’s very dangerous. Earlier this year XIV, CSFB’s Inverse volatility ETF, collapsed in price and ignited a series of stop-loss trades driving broader markets lower. It is clear why the historically generated metrics of risk that investors lean on can be wholly unsuitable for some ETFs because they don’t measure risk at all — they infer risk from returns.

Characterising the risks facing investors

With great power comes great responsibility. These words may be lifted from a Marvel superhero comic, but they’re no less appropriate when applied to the complex world of ETFs.

Ultimately, investors need to exercise a healthy dose of “optimistic skepticism” and avoid the seemingly irresistible investment narrative often presented. By becoming cognisant of the risks and challenges, they benefit from ETFs without exposing themselves to risk they are not well compensated for.

The greatest of these risks is the market risk inherent in some ETFs that are difficult to comprehend. The expertise needed to understand them is frankly beyond most market commentators and website providers. Other risks, neither documented nor well understood by investors, include credit risk, tax risk and structure risk. It’s hard to compare after-tax expected yields for investors in different jurisdictions and there is a lack of awareness around physical and synthetic ETFs. The latter category allows investors to gain exposure to asset classes and regions they couldn’t otherwise access, but there are no physical assets in the funds and the derivative counterparty credit risk is not visible to the end user, not to mention ignorance of the behavior of levered and short funds. Veteran fund manager Terry Smith has warned for years that, “the performance of short ETFs and leveraged ETFs may diverge markedly from what an investor would expect.”

Lack of transparency of real and time-varying transaction costs (bid/ask spreads) is a major challenge, as is false comparison to mutual funds with different sets of fee categories.

Welcome to the future

What investors need is unconflicted, expert partners to help them navigate the risk of investing in ETFs. Until now, such impartial assistance has been hard to come by, since the ETF landscape is built to shift large volumes of product. That’s changing as new players with sophisticated understandings of multiple asset classes and risk types enter the market. They bring disruptive business models that align with the interests of investors.

Arkera is one such company. Our AI platform brings together expert financial articles with ETFs to offer relevant, contextualised content, matched with investment products. It’s a great way for investors to get access to ETFs and learn about them in an environment that is integrated with the wider sales efforts of financial institutions.

* * * * *

This article was created in association with Arkera, an industry-changing, AI-led app that connects real-world events to unique investment stories for your clients, giving them the confidence to invest more. 

Edward Playfair