Academics at the prestigious France-based EDHEC-Risk Institute have delivered a comprehensive rebuttal to critics and scaremongers of ETFs.
The research was led by Nöel Amenc, professor of finance at EDHEC Business School and director of EDHEC-Risk Institute.
While ETFs have typically been perceived as simple vehicles combining the diversified exposure of mutual funds with the low-cost, flexibility and liquidity of trading enjoyed by publicly listed stocks, recent product development has led to the creation of more innovative products.
These new forms of ETFs, such as inverse and leveraged passive funds and funds tracking fundamental benchmarks and active strategies, though only representing less than 5% of overall assets under management in the ETF industry, have received significant criticism.
Moreover, some proponents of ETFs have intimated that established players in the traditional mutual fund industry have opportunistically used this criticism as a platform to raise more wide-ranging concerns about ETFs in general.
Criticism hasn’t just come from outside the ETF industry, however. Blackrock, the parent firm of iShares, has been vocal in calls for clearer labelling of ETFs and has raised specific concerns relating to synthetic swap-based ETFs.
While a debate about ETFs (or any financial product for that matter) is constructive, the findings of the EDHEC-Risk Institute report suggest much of the criticism and concern surrounding ETFs is unjustified.
Indeed, the report’s Executive Summary states that: “Unfortunately, we [EDHEC-Risk Institute] feel that the debate on the risks of ETFs has started off on the wrong foot and that the initial confusion has been amplified and compounded by competing interests jockeying for position, with adverse impacts not only for the ETF industry but also for the ultimate goals of sound regulation.”
Their 70-page report looked at key areas highlighted as concerns including counterparty risk, liquidity risk, systemic risk, potential risks of innovations such as leveraged and inverse ETFs, and the possibility of confusion between ETFs and other ETPs.
In each of these areas, the findings (outlined below) come out broadly supportive of ETFs.
The full report can be accessed here: What are the Risks of European ETFs?
General ETF issues
Size and Effectiveness of Current Regulatory Regime: “ETFs are only a sliver of the fund management industry. It is thus surprising to see so much regulatory interest being concentrated on a segment of the [European] investment management industry that is not only very narrow but also already the most highly regulated.”
Counterparty Risk: The issue is not specific to ETFs. Many types of funds and financial products that are routinely marketed to retail investors have counterparty risk, including funds that both hold physical securities and those that replicate returns using derivatives. This is because funds that hold physical securities “commonly engage in securities lending activities through which they can legally take on more unmitigated counterparty risk than what is allowed in the context of OTC derivatives transactions, and because, as a group, managers of physically-replicated ETFs provide investors with significantly less transparency on counterparty risk and counterparty risk mitigation.”
Classification: In response to proposals calling for ETFs to be classified based upon their method of index replication: “It makes little sense to classify instruments according to the tools they use to generate their payoffs – classifications should derive from the economic exposure.”
Labelling: “The advanced nature of the tools employed to deliver a payoff should not be confused with the complexity of the payoff itself; Should [regulators] decide to name some [products] complex…we strongly feel that this should be on the basis of the complexity of the payoff rather than that of the portfolio management techniques (e.g. scientific diversification) or investment tools (e.g. derivatives) employed. By disregarding the nature of the payoff generated by the fund to focus on the instruments it holds to generate this payoff, regulation could create a false sense of security vis-a -vis ‘simple’, ‘plain-vanilla’ or ‘mainstream’ products which in fact can include large and, more worryingly, hard to predict extreme risks. This could reduce the incentives for investors to perform effective due diligences on the actual risks of products and exacerbate adverse selection and moral hazard phenomena .”
Systemic Risk: “There is little basis to be concerned by systemic risk in relation to ETFs…The assets controlled by ETFs are but a sliver of the assets under management in the fund management industry. They are dwarfed by the capitalisation of listed equity, by the notional amount of equity futures and swaps, and their securities lending activities are marginal relative to the size of this industry. In this context, it is doubtful that risks specific to ETFs could cause systemic disruptions on equity, derivatives, or securities lending markets.”
Specific to Leveraged and Inverse ETFs
Effectiveness: “Leveraged and inverse ETFs are effective ways to gain their promised exposure to the underlying assets at the corresponding target horizon…”
Transparency: “It is surprising to find leveraged and inverse ETFs being criticised because investors might invest in these products on the basis of erroneously formed expectations or because investors may be taking potential risks that they may not have anticipated. ETF providers make it clear in their prospectuses and marketing collaterals that such funds seek to deliver a multiple return of the underlying index over a specified holding horizon, and that these funds are more appropriate to sophisticated investors who understand their mechanics and structure.”
Complexity: “The idea of magnifying or reversing performance is not at all complex and it is hard to understand what is opaque about the payoffs from such products when held as intended; the fact that their management by the ETF provider may appear more complex than that of other trackers, or that the hedging techniques used by the swap counterparty that promises to deliver the leveraged or inverse return are not immediately transparent does not make these products complex or opaque.”
Labelling: “We also think it is misguided to term these products complex or opaque when their payoffs at the prescribed investment horizon are straightforward i.e. a multiple of the tracked index. We consider that a product should not be classified as complex or opaque because of the investment techniques or financial instrument it uses.”
Market Volatility: “Last but not least, the contention that the intense rebalancing activity of this small segment of the ETF market has significantly added to the end-of-the-day volatility in their underlying markets is not borne out by currently available empirical evidence.”