Is the tide about to turn on ETFs?

RIp tide
By Angus McCrone, CA Magazine

11 August 2017

The rumoured Invesco acquisition of Guggenheim Partners could see the US fund clinch Guggenheim's retail funds business - which includes mutual funds and exchange traded funds (ETFs) - for £1.5 billion.

But the ETF market has grown directly on the back of low volatility, and some commentators are warning that the market could take a bearish turn. So where will that leave Invesco?

A market rip tide?

The stock market tide has been in, or coming in, for a very long time. Apart from a correction of just over 20% that started in spring 2015 and lasted about nine months, the FTSE 100 Index has been on a relatively smooth upwards trajectory ever since March 2009 and indeed it established a new record, of 7,447, in March.

Bull markets are common, but they are not always associated with the same smoothness as this one.

Some well-known voices have been warning that something will break the market’s unusually calm mood and cause a bearish turn.

These include UK hedge fund manager Crispin Odey, whose fund suffered a near 50% slump last year after predicting prematurely a bursting of the bubble created by central bank quantitative easing; and Paul Tudor Jones, the US hedge fund veteran, who is reported to have told an investment bank conference this spring that share valuations should be “terrifying” to central bankers.

If there is a sea change soon, one particular area of vulnerability could be those markets that have grown directly on the back of low volatility.

Exchange-traded funds

Exchange-traded funds (ETFs) have become huge conduits for investor cash into the stock market, growing to somewhere between $3trn and $4trn from their inception at zero in the early 1990s.

Straightforward ETFs tracking major indices should be able to withstand choppy market conditions, but those holding small companies or illiquid securities, or those that lend out a large proportion of their holdings to other institutions, may not be so secure.

There is also a new class of exchange-traded product that is linked to the Chicago Board Options Exchange Volatility Index or VIX, and has attracted an estimated $16bn from investors. Its solidity would face its first big test if conditions changed radically in stock markets.

A report by PwC in 2015, entitled ETF 2020: Preparing for a New Horizon, was glowing in its predictions for further expansion in these products, but in a “challenges” section said that new, actively managed ETFs would “pose a significant challenge to regulators, index ETF sponsors and other active managers. Concerns that investors may not fully understand what they are buying become even more acute as more complex strategies, including the use of derivatives, are introduced to the marketplace.”

A version of this article was published in the June edition of CA Financial Services


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