Exchange-traded funds were invented for small investors. Like index funds, which they resembled, ETFs weren’t meant to produce world-beating returns but to mirror the performance of a broad group of securities — the original ETF, State Street’s SPDR, launched in 1993, tracked the S&P 500. Funds like that were a simple way for small investors to reduce risk by diversifying portfolios. ETFs also have lower fees than mutual funds, lower taxes than index funds, and are easier to buy or sell quickly than either. Those advantages have lifted ETF-managed assets to more than $2.4 trillion in the U.S. But along the way they got less simple. These days ETFs come in thousands of flavors and are popular with hedge funds and institutional investors as well as moms and pops. An increasing number track less-traded markets such as junk debt, use derivatives or heavy borrowing to enhance returns, or laser-in on niche segments of the investable universe. That has regulators wondering whether the more exotic versions need to be reined in lest they damage investors and markets alike.
U.S. ETFs have absorbed more than $173 billion this year with about half going into ETFs that buy corporate bonds, government debt or loans. These products have ballooned to $458 billion, up from $311 billion at the end of 2014, and from $144 billion at the end of 2010. Regulators are concerned that during a market drop such ETFs may exacerbate a sell-off, since many are made up of high-yield securities that change hands infrequently. ETF providers have responded by slicing and dicing the market into increasingly specific chunks, with some products weighted toward credit quality and others toward value or stability, for example. Raising the stakes, some providers have transformed these historically passive funds into active products, with managers trading the underlying securities during the day to try to beat an industry benchmark. These ETFs currently make up less than 1 percent of ETFs but a new structure could accelerate their growth: Exchange-traded managed funds — or ETMFs in industry parlance — don't need to disclose their holdings every day, as required of their passive cousins. That could spur mutual-fund managers leery of the sector's traditional transparency to expand into ETFs.
Mutual funds allow small investors to pool their money and benefit from the expertise of professional money managers. Index funds and traditional ETFs take a different approach. Instead of hiring managers to actively buy and sell stocks, they seek to replicate the performance of a basket of securities. That allows investors who want some emerging market or small cap stocks in their portfolio to avoid the cost, hassle or risk of picking individual companies. Instead they buy a share in a bundle of securities, and that ETF share can be bought and sold much like a share of stock. The ETFs themselves engage in less trading of assets, because the underlying securities don’t have to be bought or sold when a share changes hands. That smaller turnover means a lower tax bill.
The biggest ETFs are still plain-vanilla funds like those tracking the S&P 500. How big a risk do the more exotic flavors present? Billionaire investors Carl Icahn and Howard Marks separately raised concerns about a mismatch between the ease of trading high-yield debt ETFs versus the less liquid underlying junk bonds. Even Larry Fink, who oversees the world’s biggest suite of ETFs as chairman of BlackRock, has in the past sharply criticized ETFs that use leverage, saying they could “blow up the market.” Regulators are paying close attention, particularly after finding ETFs fueled volatile trading during August 2015's stock-market rout. The Securities and Exchange Commission has since proposed limits on some ETFs' illiquid assets and leverage caps. Yet market participants are keen to heal themselves. And ETFs sailed through the Federal Reserve's first rate increase in a decade, market turmoil at the beginning of 2016 and Britain's vote to leave the European Union.
The Reference Shelf
- The U.S. Securities and Exchange Commission's liquidity management rules for mutual funds and some ETFs.
- The SEC is weighing new derivatives rules for registered funds and ETFs.
- The SEC's report on Aug. 24, 2015 volatility.
- Do ETFs Increase Volatility? Working paper from the U.S. National Bureau of Economic Research.
- Investment Company Institute paper on how ETFs work.
- A U.S. Federal Reserve study looked at whether leveraged ETFs could contribute to market volatility.
- A Bloomberg News article about an ETF market maker shows how new funds are created.
- Eric Balchunas, a Bloomberg analyst, suggests a ratings system resembling those given to movies for assessing investor risk in different classes of ETFs.
- A Bloomberg Brief newsletter on the ETF industry.
First published Dec. 3, 2014
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John O'Neil at email@example.com