Financial marketsPart 4: Risks & Reward of ETFs associated with Exotic ETFs

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Note: This is a 5-part series that covers the following areas

• Part 1: An overview of the ETFs market globally
• Part 2: Evolution of ETFs -1^st -4^th generation ETFs
• Part 3: The Future of ETFs (post 2030)
• Part 4: The Risks & Rewards associated with exotic ETFs
• Part 5: An overview of African ETF Market-Challenges faced

Part 4: Risks & Reward of ETFs associated with Exotic ETFs

Many notable exotic ETFs that at one time garnered substantial assets no longer exist, including the Credit Suisse X-Links Merger Arbitrage Liquid Index ETN (which ceased trading in June 2016), the UBS ETRACS Daily Long–Short VIX ETN (which closed in August 2016) and the U.S. Equity High Volatility Put Write Index Fund (which was liquidated in June 2017). Of course, many normal ETFs also ceased to exist during the past decade, due to a shortage of invested assets or other issues. Of the 530 ETFs trading on U.S. exchanges in 2009, only 380 remain today.

Liquidity risk is an issue for ETFs of all shapes and sizes. The secondary markets where ETFs are bought and sold typically use the average volume of shares traded as a liquidity indicator. ETF creation and redemption in the primary market can affect this liquidity by changing the shares outstanding in the secondary market. The ease of creation and redemption by the APs depends on the liquidity of the underlying instruments. Therefore, the ETF shares’ liquidity in the secondary market is indirectly dependent on the liquidity of the underlying instruments — and less so on the dollar volume of the ETF shares traded.

Factors affecting ETF Liquidity

At any time, a fraction of registered APs will be actively participating in the arbitrage process to keep ETF premiums or discounts to a minimum. If all the APs were to step away from an ETF for a short period, that ETF could act like a closed-end fund and trade at a premium or discount to the NAV. A case in point is the “flash crash” on Monday, August 24, 2015. That morning, the S&P 500 index dropped 5 percent within a few minutes of starting trading, at the same time that many NYSE stocks had a delayed opening because of a lack of bids, making it impossible for APs to establish the fair value of ETFs. Some major U.S. ETFs experienced a 50 percent deviation from NAV as many market makers stepped away from the ETF arbitrage process to minimize risk in what seemed like an irrational period in the market. High frequency trading orders exacerbated the situation and contributed to some of the strong short-term downward momentum. Stop-loss market orders from investors also kicked in, helping to prolong and intensify the crash.

Although ETFs did not cause the flash crash, some structural issues in their reopening mechanism affected their response to it. Reopening procedures were not coordinated among exchanges, resulting in different halting prices and periods at different exchanges. When trading in many of their underlying stocks halted, ETFs could not find NAVs that reflected the fair value of their holdings.

Regulators around the world are increasingly concerned that a rapid increase in market stress or a wave of selling could cause a breakdown on the market-making side of ETFs. After all, APs are not legally obligated to perform market making, and in a high stress environment they could step away or liquidate ETF units at deep discounts. If liquidity of the underlying assets were to suddenly dry up, this risk could be priced into ETF quotes. To deal with this danger, ETFs track liquidity of their assets in addition to performance, especially in less liquid fixed income markets.

At the same time, the ETF market has grown to trillions of dollars in assets during a period of relative calm and has been tested only a few times by a high level of sustained market volatility. During the March 2020 market sell-off, some prominent corporate bond ETFs were trading at a 5 percent discount to NAV before the Federal Reserve offered assurances that it would include corporate bond ETFs in its liquidity operations. Systemic risk could rise as a result of the popular practice among money managers of using bond ETFs as cash substitutes. During a market sell-off, it is not clear how easily these ETFs could be converted to cash. When fixed income money managers face client withdrawals from their non-ETF products, they might be forced to redeem distressed ETF shares for cash conversion. In such situations, price decoupling due to liquidity spread could put pressure on these institutions, increasing the risk of a broad contagion effect.

ETFs have exhibited tremendous growth over the past decade, most of it fueled by passively managed liquid products. The ETF market received an additional boost from recent changes in the U.S. regulatory environment that reduced barriers to entry and improved competition. And while both institutional and retail investors may use these exotic ETFs to fill gaps in their asset allocation and get around constraints, it is imperative that they fully understand the mechanics and risks underlying the particular ETFs they are trading.