Since their introduction over the past decade, Exchange Traded Funds (ETFs) have quickly established themselves as a standard and highly sought-after financial instrument for investors.
ETFs are securities that track the performance of a commodity or a basket of assets much in the same way as an index fund, but that trade on an exchange in the same way as a stock. Their attraction as an investment tool comes from their dexterity, as ETFs can be designed to replicate the performance of just about anything, from commodities like gold and oil, to different groupings of companies, to types of countries. Indeed, emerging market ETFs are a good example given their enormous recent popularity with the rise of rapidly developing counties such as Brazil, Turkey, China, and India.
Several days of steep sell-off on the bond market, triggered almost two weeks ago after Fed Chairman Ben Bernanke announced that the central bank would like to slow down on its massive monthly asset purchases in the near future, hit all asset classes, and ETFs were by no means spared.
But the reaction on the ETF market could not be explained away in its entirety by the general sell-off, and instead pointed to what could emerge as a significant problem with the very way in which ETFs are constructed. On Thursday June 20, one day after Bernanke’s post-FOMC press conference, not only did ETFs drop in price as traders and investors flocked to the exits, the disparity between the price of ETFs and the price of their underlying assets widened dramatically.
In other words, the $2 trillion ETF market watched as ETFs became cheaper than the actual assets they seek to track, and investors subsequently moved in large numbers to redeem those assets. After one Citigroup (C) trading desk reached its allocation limits, the bank had to stop accepting orders from ETF issuers to sell-off their underlying assets, while State Street (STT) for its part said that it would stop accepting cash redemption orders from dealers of municipal bond products.
What is of particular concern is the ability of ETFs to drag down the actual price of their own underlying assets. But this development was not entirely unexpected; A November 2010 report from the Kansas City-based Kauffman Foundation, an organization that conducts research and promotes education in economics and entrepreneurship, foretold of the predicament that was highlighted in the recent sell-off.
The report’s authors, Harold Bradley and Robert Litan, warned that ETFs pose systemic risks to the global economy that are not unlike the ones seen with the so-called “flash crash” that occurred some months prior to the report’s release. Bradley summed up this danger rather succinctly, saying “ETFs are radically changing the markets, to the point where they, and not the trading of the underlying securities, are effectively setting the prices of stocks of smaller capitalization companies, or the potential new growth companies of the future.”
The report goes on to note that while the original promise of ETFs was in their ability to provide investors with an affordable way to “assemble diversified stock holdings,” the funds are now “undermining the traditional price discovery role of exchanges, and in turn, discouraging new companies from wanting to be listed on U.S. exchanges.”
The bloodbath for ETFs that was seen at the end of last month, however, was not just limited in its consequences to deterring or even harming aspiring growth companies from entering the market. Rather, Citigroup and Sate Street’s temporary suspension of sell orders point to more ominous consequences resulting from the ETF market’s ability to artificially distort the costs of underlying assets.
The result is a situation in which the ETF’s relationship to its underlying assets becomes parasitic, and this could have drastic consequences for the global economy. Emerging Market economies, who have seen an influx of investment thanks to the popularity of Emerging Market ETFs, could take a serious hit if the type of outflow that has been seen over the past two weeks gets any more serious than it already is.
Furthermore, there is no telling what form the reaction from investors would take if the practice of “temporarily” preventing them from cashing out on underlying assets spreads from Citigroup and State Street spreads to other financial institutions in the event of a more severe sell-off.