ETFs under fire

Even as the exchange-traded funds (ETFs) industry expands, headlines are calling the funds into question: The Globe and Mail advised “How to protect yourself from ETF pain” just days after the May “flash crash,” and more recently, the Financial Post linked the two, with the headline “ETFs called a ‘Frankenstein’ that creates risk of ‘flash crashes.’” Even when the tone is somewhat conciliatory, such as the Wall Street Journal’s, “Are ETFs a menace — or just misunderstood,” it’s far from upbeat.

The truth can be hard to discern. Yet, if ETFs are so problematic, why is their use in institutional and retail investor portfolios expanding at such a rapid rate? At the end of the third quarter of 2010, there were almost 200 exchange- traded product (ETP) listings, with assets of more than US$35.3 billion from six providers on one exchange. Assets in ETFs/ETPs listed in Canada have increased by more than 23% on a year-to-date basis while the markets—as measured by the MSCI Canada Index in US dollar terms over the same period—grew less than 7%. It is natural for any success story to raise questions, so it is important for the investment community to be well informed, and separate myths from reality.

More investment choice

Many factors are driving the ETF phenomenon, but simplicity and choice may be at the heart of its success: ETFs have vastly increased the investment choices available without adding complication. They are easy to use, and have become the essential tool for advisors to use when building high-quality, complete portfolios for their clients. ETFs have also set a new standard for transparency in the financial industry. Apart from most other financial products, ETFs are described plainly and precisely — the name of a fund alone is rich with information.

ETF Centre, ETF filter tool

The engineering that makes ETFs possible is designed to harness the power and efficiency of modern capital markets and to protect investors from the structural weaknesses inherent in traditional mutual funds. The design manifests itself in the form of three core ETF benefits: transparency of holdings, the flexibility of real-time trading on the stock exchange, and cost efficiency. Another benefit that results from this design is, unlike mutual funds, ETFs can be sold short.

It is this aspect of ETF trading—the short sale—that has been the source of great misunderstanding. Several commentators have recently suggested that the short- selling of ETFs creates a risk of both systematic market disruption and the potential “collapse” of an ETF. Unfortunately, these claims are based on a fundamental misunderstanding of how ETFs function and how their portfolios are built. In fact, the “collapse” of an ETF would require a fund to distribute its assets to market participants who are not rightful unitholders of the ETF, a scenario that is essentially impossible. That risk is remote, thanks to long-standing legal restrictions on deliberate naked short-selling and is eliminated altogether by robust procedures that prevent even a single penny of an ETF’s assets from being delivered out before the validity of a redeemer’s holdings is confirmed.

The notions that a hypothetical short-squeeze on an ETF could trigger market panic — or that ETFs were the cause of the “flash crash”— are equally unfounded. ETFs are open-ended funds, and grow (or contract) by the in-kind delivery of securities to (or from) the fund. This creates a tight linkage between the ETF itself and the securities that it holds. If additional ETF units are needed—whether to meet investor demand or to cover short positions—they can be created with ease.

The supply of additional units is as elastic as the supply of the securities it holds, and while a growing proportion of investor activity occurs through ETFs, they remain small relative to the size of the total market. It is the overall market that drives the value and prices of ETFs, and not the other way around.

Certainly, the events of May 6th remind us that trading can be unpredictable. But while it is true that many ETFs were affected by the so-called “flash crash,” they weren’t the cause. The U.S. stock market, already anxious over debt concerns in Greece, started to retreat, which resulted in a severe mismatch between the supply and demand of liquidity. The structural features of the market that are designed to ensure orderly trading, weakened by confusion and widespread uncertainty, failed to correct these imbalances and prices fell rapidly. Like many common stocks, ETFs were swept away with the tide.

Ultimately, the flash crash exposed weaknesses in market structure, not in ETFs. ETFs are no longer a specialized product; their numbers in Canada attest to their importance. As attention and awareness grow, it is critical for investors and advisors to be properly informed. In today’s environment, the value of precision and transparency cannot be overstated, so it should be no surprise that the use of ETFs by advisors continues to grow.

The same can be said of investors: in a recent survey, 35% of investors indicated that they expected their use of ETFs to increase in the upcoming year. As traditional options reach their limits, ETFs will continue to offer the best source of new choices for investors. The ETF industry is unique in its responsiveness and singular focus on building the innovative products that investors need. From gold bullion to emerging market stocks to real return bonds, ETFs often provide investment options that are simply not available elsewhere. Those who have yet to embrace these options are at risk of being left behind.