How Safe Are ETF’s?
Henry Jennings
I received an email this morning regarding ETFs. Everyone has heard of ETFs and many are suspicious of them. The question many ask is what happens in a market crash? How will ETFs perform and will they survive?
Firstly, what is an ETF?
At its core, it is an instrument that replicates the performance of an underlying asset. That could be an index or a group of stocks or even a commodity or currency. It is a simple cost-effective way of getting exposure to that asset without the hassle of picking stocks or making too many complicated decisions. You like Asia, buy an ETF that gives you exposure to a bunch of Asian stocks. It is simple.
An ETF is a form of Exchange Traded Product (ETP), there are others.
My, you have grown
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- New All-time high of $61.bn market cap. Half of CSL.
- Now 258 ETPs on the ASX.
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Now ETFs come in two varieties. The ‘Vanilla’ or the ‘Rum and Raisin’. ‘Rum and Raisin’ is the exotic ETF products. These have bells and whistles. Leverage.
Most investors stick to the Vanilla flavour ETPs. 67% of the inflows last year were into Vanilla. ETPs. Only 21% into active and 11% in Smart Beta as it’s called. I call it ‘Rum and Raisin’.
The ETP market is backed by some of the worlds biggest and in theory the safest issuers. It is in their interest to create and maintain orderly markets.
In the event of a crash, investors have long memories of which issuers did the right thing and maintained liquidity and those that just ran for the hills. The good guys know that crashes pass and they want to be around for the next phase of the market. ETFs are good business after all.
The ‘Rum and Raisin’ ones carry far more risk. These are leveraged or have added smarts. Maybe some chocolate toppings or a flake. In the event of a ‘sudden market death syndrome’, these toppings can be lethal. Liquidity is always the issue. If you as an investor wants to sell, the price you get should reflect the value of the underlying basket. In the old days this was almost a manual thing when I started out with baskets of stocks and a semi- ETF whilst at Macquarie. Now it is all done by computer trading systems. At the blink of an eye, the computer will sell the underlying basket and thus ‘hedge’ the issuer's exposure. This the ETF should trade at or close to the underlying asset price. That is easy (ish) in the Vanilla stuff but when the custard hits the blades, the smart leverage bit hits hard and the liquidity may not be there. That is when you get issues.
So, to answer my friends’ email. ETFs have not been tested in a crash no. What we have seen in modern 21st Century markets, with the growth of ETFs and passive products, is that momentum can drive markets and feed on itself. It happens in bull markets and it happens in bear markets. You cannot tell me that the movement in Tesla in the last month is normal. Its short squeeze and these index funds being forced to buy more as the price goes up. Bigger price, bigger weighting, it is self-fulfilling. When it reverses quickly, getting out can be an issue. It increases volatility.
ETFs selling will undoubtedly increase pressure on the market in times of trouble.
However, consider an investment in a fund manager, you want to get your money out of that fund as the market crashes. How hard is that to do? Some during the GFC, froze redemptions as the underlying assets were impossible to liquidate. Even recently in a bull market, there have been serious problems for some with funds in a UK fund run by Neil Woodford. A fallen star fund manager.
The truth is when liquidity dries up, it will not be just ETFs that suffer. It will be funds and investors alike. As they say, even the pretty girls get caught in a bus crash. Not sure who they are but I know they say it.
The ETFs at least have some transparency (Vanilla ones that it), so at least you know what they hold. Do you know what your fund manager holds? Many only report quarterly or monthly. Some only the big positions. Some are less than transparent and that becomes a risk to investors. Not only how do I redeem but what the hell did I invest in anyway? Motherhood statements are all well and good, but every fund manager does that. Its SOP.
Just like investing in trusted brands and managers, so too it pays to invest in trusted ETF issuers and ones that are the vanilla. You always know what you are getting, and it won’t stain as much as the exotic ones. iShares is backed by BlackRock one of the worlds biggest fund managers after all.
The growth of these products is a testament to how successful they have been and how they have filled a huge gap in the market for investors looking to diversify and get exposure to other areas of global trends.
Some of the popular ETF themes for 2020.
NASDAQ – Ever higher and higher. Hard to get the same exposure from ASX stocks. NDQ is a good way to ride the US tech boom.
Emerging Markets are another area of potential outperformance in 2020. Not an easy one to research as a retail investor so voila the Emerging Markets managed fund from Legg Mason 40-60 companies across markets and sectors. EMMG. Maybe a bit Rum and Raisin.
Want to invest in China? CETF – a China CSI 300 ETF. A Vanilla one. It replicates the CSI 300 a market weight Chinese index. There are others for Asia. Even India if you feel the urge.
Want to buy into Brexit and UK recovery? – Simple a FTSE 100 index ETF F100. Top 100 companies on the FTSE. Another Vanilla market weight ETF.
One big area of growth of ETFs last year was Bond/Fixed interest ETPs. QPON is an Australian Bank Floating rate bond ETF. Provides exposure to a portfolio of some of the largest and most liquid senior floating rate bonds issued by Australian banks. 80% weight allocated to binds issued by big four.
There are also ways to hedge through ETPs with products like BEAR that profits from market falls. Another Betashares product. The market goes down, ETF goes up by the same amount. Very Vanilla.
All major ETP provider have plenty of information on all flavours of their products.
Conclusion
ETPs are great products. They offer very cost-effective simple ways to get exposure to other markets and assets. Like most things in life, stick to the brands you trust and keep it simple. Cannot go wrong with a good Vanilla ice cream. In a crash if and when it comes, it is not just ETFs that will be stress tested. We all will be.