The press has been abuzz about potential systemic risk concerns stemming from ETFs of all sorts, and this crept into our holiday conversations as well. The events of August 24, 2015 have shown that equity ETF mispricings can occur and can be serious. But are equity ETFs fundamentally in trouble, and are they a cause for a broader industry-wide liquidity concern in 2016?
First, what happened in August: our understanding is that some US equities opened late and saw high volatility, which led to ETF market makers not receiving market pricing and accurately arbritraging their derivative ETF products back into shape. This was an intraday incident and was quickly resolved. However, some ETFs, notably the Guggenheim S&P 500 Equal Weight ETF (RSP), which typically trades very closely to the fair value of the underlying securities, were hit hard. For an hour on August 24th, RSP was trading 30% below the fair value of its tracking stocks. That’s pretty bad.
The August events have sparked a broader conversation including whether ETFs, as derivatives, are safe in general. All the evidence thus far suggests that ETFs are just as stable as their underlying securities. Disruption in equity or bond market liquidity is going to negatively impact ETFs no matter where or why it occurs. An October 2015 research report, “ETF Liquidity” by three Massey University (New Zealand) professors finds some logical conclusions:
1) There is a strong relation between ETF and underlying stock liquidity.
2) Both supply- and demand-side factors have a strong bearing on ETF liquidity.
3) Liquidity risk is priced in ETF returns.
The US SEC supported their own ETF liquidity paper but this version is sort of like the tail wagging the dog (“Do ETFs Increase Volatility?“, March 2015). The authors looked at whether ETF liquidity helped increase the volatility in underlying stocks. The upshot is that yes, “stocks with higher ETF ownership display significantly higher volatility.”
Together, these papers suggest that there is a two-way relationship between the liquidity and volatility of ETFs and their underlying securities. So how is equity market liquidity looking these days? It arguably looks pretty crummy on a worldwide basis, from Singapore’s SGX delaying their IPO in part due to poor liquidity, to Pensions and Investments Magazine reporting that US investors are worried, to “UAE brokerage firms hit by thinning stock market volumes.” Localized versions of the story vary, but globally, Basel III and its domestic variations have put a real damper on banks providing liquidity, which means that natural buyers and sellers have to meet in the middle. There just aren’t enough of them, particularly in fragmented markets, to support an expected level of low price volatility. A lower level of liquidity is not inherently bad, but investors need to adjust their expectations when transacting in the markets. This adjustment may not have happened yet everywhere that it needs to.
We’ve also noted that regulations are encouraging banks to trade swaps with their hedge fund clients instead of engaging in physical financing transactions on both the long and short side. For more on this, see our December 2015 research report, “Regulatory Costs of OTC Derivatives vs. Securities Finance Transactions.” This is a really big deal and is only set to increase through 2016.
This brings us back to the initial question: should we be worried about equity ETF risk? The answer is whether we are worried about equity market liquidity, and that answer is yes: we expect equity market liquidity to worsen from 2015 to 2016. ETFs are a derivative, and anything that impacts the underlying (bonds or equities) is going to impact volatility, redemptions and operational flows in any derivative product. This means that ETFs are subject to concern: the less liquidity in the underlyings, the greater the potential for operational or withdrawal issues that could have knock-on impacts. Markit is working to mitigate the problem by publishing a list of safe ETFs for securities lending collateral, but historical data does not mean that an ETF is secure tomorrow. Its not a fault of equity ETFs per se, but you can’t have a smooth derivative market without a liquid market in the underlyings, and we’re just not seeing that right now for equities in 2016. The potential exists for more equity ETF disruption in the coming year.
