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Exchange-traded products weathered perhaps their biggest challenge yet during the recent market decline and came through relatively unscathed despite some searing headlines.
A very specific type of product called an exchange-traded note took much of the market focus during the decline. That group suffered huge losses after a sustained bet against volatility suddenly blew up.
Ultimately, though, ETNs make up a very small part of the market. While watching at least one of the so-called low-vol funds blow up was stunning, it had little overall impact on the market, which over the past two sessions, including Monday, had made up a good deal of the previous losses.
"We just saw the largest-ever percent gain in the VIX and the largest-ever single-day point fall in the Dow. ETFs performed better than they've ever performed," said Martin Small, head of U.S. iShares at money manager BlackRock. "They've become an integral part in risk management and hedging."
BlackRock is the biggest player in the ETF market, managing nearly $1.4 trillion of the industry's $3.4 trillion in assets under its iShares umbrella.
The firm pointedly last week released a statement reminding investors that it does not offer the type of exchange-traded product that generated so much talk around the market. The short-vol notes are part of a $50 billion sliver of the total ETF space that uses leverage to bet for or against certain indexes and strategies, often providing double, triple or in a few cases quadruple the returns of the underlying index.
"They're completely different than traditional exchange-traded funds," Small said. "They use financial engineering, and in a stressed market they don't perform the way many investors would intuit for them to perform."
The issues with the short-vol and leverage funds come amid a heated contest between active and passive strategies.
Active managers, seeking to stem a powerful influx of funds into ETFs over the past several years, have tried to paint the competition as landmines ready to blow during sell-offs of the type that occurred in February. They argue that investors who believe they have diversification because they own index funds are actually betting on just a handful of stocks that move those indexes.
Indeed, when an index like the S&P 500 tumbles and holders of, for instance, the $256 billion SPDR S&P 500 Trust ETF run for the doors, the individual components will sell off as well. That's what happened last week — but that is what's supposed to happen.
"When that happens, you get the classic risk-off-everything sell-off," said Nick Colas, co-founder of DataTrek Research, who has been on top of ETF trends since the industry was in its infancy. "There is no differentiation, and correlation spikes as a result."
Others express more serious concerns, namely that managers of the indexes won't be able to keep up with redemptions in times of heavy market stress.
"I'm particularly worried right now about a potential liquidity crisis that is deriving in the ETF market, when we're seeing not only the inverse volatility ETF structures being disrupted, but we're starting to see real flights from the ETF market," Daniel J. Arbess, Xerion Investments CEO, told CNBC.
While Arbess alleged that the SPDR S&P 500, or SPY, was getting "backed up in meeting its redemption requests" and not accurately tracking the index, Small said, "if anything we've seen the opposite" in overall ETF transactions. The SPY fund appeared to be trading in close line with the S&P 500 Monday afternoon.
"Every time I read something about ETFs or an index impacting the market, I look to see if anybody has delivered numbers and supporting facts," Small said. "There are no numbers or supporting facts."
Interestingly, while the S&P Trust fund was the biggest loser in investor outflows over the past week, at $23.1 billion, its BlackRock counterpart, the iShares Core S&P 500, saw the biggest inflows of any stock-focused ETF, with $1.1 billion.
Still, investors have grown leery of ETFs, at least in the near term.
During last week's brutal volatility, investors pulled $29 billion out of stock-focused funds, with inflows for all other sectors about even. Still, year-to-date, ETFs have seen $28.1 billion of inflows, according to FactSet.
That continues a powerful trend. For all of 2017 investors put $691.6 billion into passive funds, which mostly entails the ETF space, while pulling just shy of $7 billion from active. The numbers are even more pronounced for U.S. equity funds — $220.3 billion of inflows vs. $207.5 billion in outflows, respectively.