Since the roll out of the first exchange traded fund in 1993 by State Street Global Advisors, the financial industry has hailed ETFs as the perfect investment vehicle. Advisors claimed that ETFs were practically free of any pitfalls that plagued other investment vehicles that came before.
ETFs provided the ability to trade intraday, unlike mutual funds, which only trade based on day-end price. Also, unlike closed-end funds, ETFs have a mechanism that allows investors to redeem or purchase additional shares if there is a disconnect between the share price and the net asset value.
On paper and in theory, ETFs appear to be the pinnacle of investment products — allowing investors to gain low cost exposure to a wide variety of asset classes that otherwise are not readily accessible. However, despite all of these built in protection mechanisms, ETFs are vulnerable in certain conditions and may not operate exactly as intended.
With any financial investment, individual and institutional investors need to consider all risks involved. This is as true with ETFs as it is with any other security. On a structural level, ETFs have been engineered to provide extensive diversification, liquidity, very low spreads and relatively low costs — all while also providing outstanding liquidity.
These have been to the benefit of passive index investors who want to create simple portfolios that track both equity and fixed income indices. Yet with the boom in popularity in ETFs in the past 10 years, this seemingly perfect investment has fallen victim to some of its own unique unintended consequences.
At the end of 2004, there were 152 ETFs with a collective market value of $228 billion. By the end of 2014 there were 1,411 ETFs with a collective market value of $1.97 trillion. This tremendous growth in the ETF industry has put a strain on market liquidity.
In a normal investing market environment where market participants are acting in a rational manner, ETFs work as intended and become a powerful investing tool for market participants. However, when markets experience periods of extreme volatility, as they did recently on Aug. 24, the shortcomings of ETFs become apparent.
For example, the disconnect between the price and net asset value of the Powershares QQQ Trust Series ETF (which tracks the Nasdaq 100 Index) on Aug. 24, illustrates exactly what I am referring to.
At the start of trading on that Monday morning, selling pressure was very heavy as a result of the Chinese stock market being down considerably. As a result, markets opened down and many investors tried to sell shares early to get out of positions before they continued to go down further. It was here that ETFs began to disconnect and began to break down in the market.
QQQ traded in a range of $84.75 to $89 within the first minute of trading despite the net asset value of the share being worth around $92. The disconnect was persistent for the first 5 minutes of trading that day and individuals selling QQQ were losing an additional 3 percent to 7.5 percent more than the actual holdings were down.
ETF market makers (who typically are incentivized to trade in the ETF by taking advantage of arbitrage profits when market prices disconnect from the net asset value) had trouble accurately pricing the ETF baskets due to individual stocks comprising the index being halted — which also impacted sourcing liquidity on the underlying basket of securities. Because of these conditions, market makers allowed prices to disconnect due to a lack of confidence in their ability to protect and hedge their risk.
A breakdown in liquidity in the market revealed that ETFs themselves are not as perfect as they may be portrayed. As several publications pointed out in the days after that volatile August day, an ETF cannot be more liquid than the underlying securities that make up the ETF. This should be cause for concern especially for investors in bond ETFs where the underlying bond market is very illiquid and even more likely to result a disconnect in between market price and net asset value in extreme market conditions.
With the case of QQQ, the impact of the underlying securities being halted from trading caused the ETF’s liquidity to breakdown and forced those who wished to sell to accept a price below the market value of the true price of the underlying securities.
ETFs are a great investment vehicle. They have provided investors, and especially individual investors, great opportunities to gain market access to sectors and asset classes that once were unattainable — while also reducing fees and providing intraday liquidity. Like all financial products they are susceptible to failing and breaking down. It is only recently that these pitfalls of ETFs have begun to reveal themselves, especially as they continue to grow and become more of the market.
Byron S. Sass is a fixed income analyst/account manager for Karpus Investment Management, a local independent, registered investment advisor managing assets for individuals, corporations, nonprofits and trustees. Offices are located at 183 Sully’s Trail, Pittsford, N.Y. 14534; phone (585) 586-4680.