When the market turns, what happens to ETFs?

The fast-growing ETF sector is poised to sustain its momentum with investors, potentially raising new risks for markets, investors and regulators, according to a new from the Investment Industry Association of Canada (IIAC) published on Monday.

The IIAC’s report considers the impact of the burgeoning ETF market both in Canada and for global markets. The report notes that although recent market swings haven’t exposed any systemic issues in the ETF space, these funds also haven’t been truly stressed by a prolonged market downturn.

In particular, the report says that there are concerns that liquidity, collateral and counterparty risks that materialize in the ETF space under highly stressed market conditions could mushroom into systemic risks, such as investor runs on the funds that then cascade into underlying asset markets, amplifying the turmoil.

At the same time, the report also notes that some market observers believe that compared with mutual funds, ETFs feature multiple layers of liquidity that should guard against specific issues evolving into systemic risks.

Nevertheless, the IIAC’s report cautions that these theories have yet to be exposed to real world market conditions.

“The real test will be when there are heavy redemptions across multiple sectors and how ETFs perform, particularly in less liquid sectors of the market,” the report states.

With that in mind, regulators are becoming increasingly vigilant, the report notes: “Despite the lack of direct evidence that ETFs could be vulnerable in a downturn, regulators have increased their supervision resources to monitor developments in this important and growing sector.”

Indeed, to ensure that concerns about ETF liquidity and other risks don’t materialize into systemic issues, the IIAC recommends that investors, regulators and investment industry firms “must remain informed and diligent when evaluating the risks and benefits of new products.”

The report also suggests that ETF providers “need to be willing to retire products and strategies that underperform”; to devise new products to replace these under performers; and that they must be prepared to handle changes to industry regulations as well as tax and accounting rules that affect ETFs and investors.

James Langton

James is a senior reporter for Advisor.ca and its sister publication, Investment Executive. He has been reporting on regulation, securities law, industry news and more since 1994.