The value of exchange-traded funds globally has increased five-fold since the financial crisis.
- Global markets have sold off aggressively in the last three days.
- One concern during the sell-off is the fate of the rapidly expanding ETF sector.
- The value of exchange-traded funds globally has increased five-fold since the financial crisis.
- The sector, however, has never really been exposed to a prolonged downturn, and their are concerns about how it will cope.
LONDON – The global market correction got very real, very fast.
On Monday, the Dow Jones had its biggest one day fall in history in points terms, then as Tuesday came in Asia, the Nikkei dropped as much as 6%, and in the European morning, major indexes in Germany, France, and the UK had dropped more than 3%.
Several market participants told Business Insider's Rachael Levy that the acceleration of the sell-off in the US was largely down to machine-based trading systems. "It felt like the machines took over," one analyst said.
The recent rise in popularity of passive investing is also to blame, at least according to Stefan Koopman, an analyst at Dutch lender Rabobank, who said in a note that the rise of products like ETFs has helped to create an environment where moves in either direction can accelerate and "snowball" rapidly.
"From a somewhat broader perspective, the dominance of passive over active investment — including the popularity of ETFs and other index tracking products — has set up an environment in which the size and speed of moves down could easily snowball," Koopman wrote to clients.
"The market is positioned homogeneously, ie long the index, and is therefore selling homogeneously . . . Fasten your seat belts!"
The current correction — most analysts don't see the past couple of days turning into a sustained long-term crash just yet — is now set to provide a perfect testing ground for ETFs.
Investors have poured money into ETFs in the past handful of years because when times are good they are a hugely attractive prospect. Not only are fees generally lower than investing in vessels like mutual funds, ETFs also offer investors a greater deal of flexibility.
The products have never really been tested in a true downturn, and many in the market are concerned that when a downturn does come — as it is currently — things could get messy.
The fear is that ETFs have created their own bubble-like momentum: As ETF returns have beaten active managers, more money has gone into them. As more money goes in, the price of the stocks being bought rises. Those rising values attract more money, and so on. ETF investors don't care whether stocks are over-valued, only that they're buying a representative slice of the market.
But that virtuous circle could become a vicious cycle.
This is especially true when considering that some believe ETFs can distort the markets by encouraging investors to put money into big companies — simply because they're big names — regardless of their market fundamentals (things like price-earnings ratios, return on equity etc.)
Back in September 2017, Deutsche Bank strategist Jim Reid put it like this:
"One argument is that passive investing naturally favours large caps when picking constituents based on factor style (for example momentum, growth etc). In theory this means that the biggest companies are getting bigger, regardless of fundamentals.
The concern therefore being that these companies are perhaps more susceptible to overvaluation and the gap between the small/mid to large caps also widening. This could potentially mean that risks are amplified when you see a big market correction, which arguably ETFs haven’t yet been tested with yet."
Peter Dixon, an economist at Commerzbank told Business Insider last year that his "concern would have to be that they give the impression that there's lots of liquidity out there. But if everybody is trying to get out at the same time, the question has to be, do ETFs exacerbate or magnify the impact of the decline?"
"ETFs and ETPs have not yet been fully tested in a sustained bear market. So the real test could be when we see the next downturn and these products are faced with heavy redemptions. This will be particularly paramount for less liquid asset classes," Deutsche Bank's Reid added.
People could get badly "burned" once a market downturn does come, Dixon said.
"They're bubbly, and might have also contributed to the recent rally in equities anyway, because everyone is jumping into them."
"I'm just a bit concerned that if and when equities themselves turn around, and they might if US rates start to rise rapidly, you might start to see people starting to get burned," he added.
Some have already been burned. As BI's Joe Ciolli reported, the VelocityShares Daily Inverse VIX Short-Term ETN (XIV) and ProShares Short VIX Short-Term Futures ETF (SVXY), both of which are designed to provide single-day returns that are the inverse of the VIX (Wall Street's volatility index), falling sharply on Monday.
Valued at a combined $3 billion before the market reckoning, the two products are now worth just $150 million, according to Macro Risk Advisors (MRA).
What helps accelerate a boom can also deepend a bust.
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