From Paul Jacobs:
Common wisdom says the bigger an industry is, the harder it falls. Moody’s Investors Service recently suggested that the $3.4 trillion exchange-traded fund industry is due for a nasty tumble.
As Bloomberg reported, a team of analysts at Moody’s warned that ETFs could make a market crisis worse. ETFs sometimes hold illiquid investments that could be hard to sell in volatile market conditions. This, in turn, could make the ETFs themselves harder to trade in times of high volatility. Moody’s analysts noted that “These ETF-specific risks, when coupled with an exogenous systemwide shock, could in turn amplify systemic risk.” Market makers generally try to balance supply and demand for ETFs and their underlying assets; the report suggests that if liquidity dries up, market makers would price extra risk into ETFs as a consequence. This means investors could end up stuck with ETFs that are suddenly expensive or difficult to trade.
The ETF market has expanded rapidly since the funds first appeared in the early 1990s. According to Vanguard, more than $311 billion flowed into ETFs industry-wide in 2018 alone. Most of this ETF expansion has happened during an era of unusually low market volatility.
Like mutual funds, ETFs serve as a useful tool to allow investors to diversify their portfolios. Unlike mutual funds, however, ETFs trade throughout the day, giving investors access to real-time pricing. More trades, unfortunately, mean more opportunities for something to go wrong. ETF prices have the potential to deviate significantly from their underlying assets during a trading day. Mutual funds, on the other hand, simply add up the value of their securities at the end of each day and use that number to calculate a daily price per share. In other words, mutual funds can dictate their share price, while ETFs don’t have the same ability.
In normal market conditions, this distinction doesn’t matter much. But in times of major market stress, it can make instability more pronounced. Since the 2008 financial crisis, ETFs have played a role in several market flash crashes. No one has seen what a large ETF market looks like in a sustained period of volatility. So Moody’s may be right, at least in part, to sound a note of caution.
If ETFs entail more risk than mutual funds, why should investors use them at all? As with many investment classes, the answer depends on when and how an investor uses the funds. At Palisades Hudson, we use some ETFs but not others. When evaluating an ETF, one of the most important considerations is its underlying holdings and how liquid they are. If an ETF holds illiquid assets, such as high-yield bonds or stocks of very small companies, the fund is likelier to encounter problems if it is overwhelmed with buy or sell orders. Our firm prefers to use ETFs that hold very liquid securities. In this way, we can steer our clients clear of assets that would represent significant risk in the event of a liquidity crisis.
Investors can also protect themselves in times of extreme market stress by refraining from trading their ETFs. At Palisades Hudson, we have sometimes restricted traders from trading ETFs during periods of high volatility, preferring to wait until conditions settle and we can be sure that we will receive a proper price per share. Because we do not trade frequently in client accounts – in fact, we try to minimize trading to reduce costs – we expect our clients’ investments in index funds to resemble their underlying indexes, with as little potential for deviation as possible. For us, ETFs are attractive because of their low expense ratios, not their ability to trade throughout the day. If an ETF holds liquid securities and has a lower expense ratio than an index mutual fund tracking the same index, choosing the ETF to reduce costs generally involves little extra risk, as long as you commit to a buy-and-hold strategy.
None of this is to say that mutual funds are immune from risk in the event of a significant market downturn. The nature of mutual funds’ holdings, and how liquid they are, will also determine how they perform during such a period. However, since mutual funds only issue one share price per day, there is less that can go wrong than with ETFs, where tens of millions of shares are traded on an intraday basis.
The report from Moody’s notes that technology may eventually mitigate at least some ETF-specific risks. Traditional banks seldom act as ETF market makers these days. The firms that have stepped into the role increasingly use technology to, in part, help preserve ETF liquidity. Investors should bear in mind, though, that artificial intelligence is not a magic bullet. At least for the time being, the risks remain.
Moody’s report should give investors reason to reflect but should not necessarily scare them away from ETFs outright. When you choose a fund, think about the risks involved in a particular ETF based on its underlying holdings. And remember that the more you trade, the more exposure you have to mispricing and other risks. As always, a disciplined, long-term strategy can help investors steer clear of emotional reactions to market moves.
The SPDR S&P 500 ETF Trust (SPY) was unchanged in after-hours trading Wednesday. Year-to-date, SPY has gained 8.50%.
This article is brought to you courtesy of Palisades Hudson Financial Group.