4 signs of a potential ETF apocalypse now
ETF companies have been associated with flash crashes, Wall Street bankruptcies and reckless market bets. What could possibly go wrong next? The good news is, probably nothing too drastic. After all, ETFs have already weathered quite a bit of uncertainty in their now-decades-old history.
"We really went through a time period that put ETF structures to the test," said Jim Wiandt, CEO of ETF.com. He meant 2008 and 2009, when Lehman Brothers was going down—and taking with it the most widely tracked indexes in the fixed-income ETF space. There were exchange traded notes (ETNs) with full credit exposure to banks on the verge of bankruptcy (including Lehman).
This isn't to say ETFs don't have pressure points, especially the bigger the industry gets. The biblical apocalypse had four horseman; ETFs have four major risk factors, according to the experts. Here they are.
Risk # 1: Liquidity crunch in smaller markets
There has been a huge flood of assets into the fixed-income space in ETFs, from bank loan portfolios to high-yield and emerging markets bonds. That is not necessarily a good thing. "It has really changed how those fixed-income markets work, because you have huge concentrations in small areas of the market," Wiandt said. And that could pose a future threat to liquidity in those smaller markets.
With ETFs it is easy to sell them on market, and if there are huge outflows in more "granular" areas of the market, there can be a crunch on liquidity and the ability to create and redeem ETFs at a good price. For example, "There is a big percentage of assets in the loan market, so there could be a liquidity crunch there if a big selloff happens," Wiandt said.
There is a flip side to the greater weight that ETFs pull in the fixed-income market.
Tyler Mordy, president and co-CIO of HAHN Investment Stewards, noted that in 2008, when the markets were plummeting, the high-yield bond market almost froze. But "ETFs tracking high-yield bond markets continued trading, providing much-needed liquidity. "The ETF vehicle provided better price discovery than the actual underlying asset," he said.
"It's a continuing issue," Wiandt said, adding, "The ETF industry has to address it, and it doesn't always do so."
(Read more: The most unusual ETFs on the market )
Risk # 2: Lack of secure exchanges and market structures
During the flash crash that occurred on May 6, 2010, when the Dow Jones Industrial Average plunged about 1,000 points (only to recover its losses minutes later), there were a number of ETFs that dropped to a price of zero on electronic trading platforms. The problem that occurred was more of a market structure issue than an ETF issue. Nonetheless, if the underlying assets in a fund are not trading, then neither will the ETFs. "So if there is a widespread issue in the market, it will have widespread issues for ETFs as well," Wiandt said.
"You can't blame the flash crash on the availability of ETFs," Mordy said, but part of the problem was that "some of the exchange infrastructure was not modernized enough to take care of ETFs and the liquidity needs."
Since ETFs do trade on exchanges like stocks, there is a more general risk related to market vulnerabilities. "Something that concerns me deeply is the threat of cyberterrorism and the security and integrity of the electronic exchanges," said James McDonald, CEO and CIO of Index Strategy Advisors. He pointed to recent outages at options exchanges and major stock exchanges and imbalanced orders. "For the past 18 years, I have observed the market nearly every trading day, and nowhere in that time have I seen market disruption for no apparent reason like I have in the last year, and it deeply concerns me," he said. "Regardless of how good your portfolio strategy is ... if the markets are compromised, we could all experience catastrophic losses," he added.
(Read more: It's a myth low fees are reason to buy ETFs)
Risk # 3: Synthetic ETFs
One of the most challenging structures in the ETF space today is the single-provider "synthetic" ETF. "Synthetic ETFs invest—or may be directed to invest by the swap counterparty—in securities (the 'substitute basket' or 'collateral basket') that may be unrelated to the benchmark index and also enter into a swap agreement with one or more counterparties who agree to pay the return on the benchmark to the fund," according to a recent Vanguard Group paper on the topic. "Thus, a synthetic ETF's return is guaranteed by the counterparty. More specifically, even though there are two synthetic ETF structures (an unfunded and a funded swap structure), in both cases the swap counterparties are responsible for providing the index's return to the ETF investors."
In these cases, there is no "separation of powers"—a single entity, usually a bank, designs the fund, selects the collateral, vouches for its quality and value, writes a swap contract to make up the difference and then makes payments to keep the swap current.
"Now just ask yourself: What if Lehman had done a large suite of these in 2008?" asked Lee Kranefuss, former CEO of iShares and executive-in-residence at Warburg Pincus. "ETF managers who have really developed scale have been independent, fiduciary-minded investment managers," Kranefuss said.
The good news is that synthetic ETFs are much more popular in Europe than in the U.S.—due to regulatory restrictions in the U.S. under the Investment Company Act of 1940, as well as tax regulations overseas that make the structure more attractive. The Vanguard June 2013 white paper reported that 35 percent of European ETF assets were in synthetic portfolios while only 2.9 percent of North American ETF assets were in synthetic funds. Synthetic ETFs represented 17 percent of North American ETFs as of June 2013, but 69 percent of European ETFs.
So at least warn your European cousins.
(Read more: Emerging markets ETFs: Which to hold, which to avoid)