Liquidity and Leverage Both Issues for ETF Investors

Liquidity and Leverage Both Issues for ETF Investors

Liquidity and Leverage Both Issues for ETF Investors

The amount of assets held in Exchange Traded Funds (ETFs) has increased dramatically over the past decade. In April, aggregate ETF holdings topped $3 trillion for the second time in as many years. Investors have been drawn to ETFs, in part, because of their low expense ratios and fees relative to mutual funds. While the emergence and growth of ETFs has generally been a positive development for investors, there has been, and continues to be, a learning curve when it comes to the risks associated with ETF investing.

Key Features of ETFs

  • Like mutual funds, ETFs are pooled investment vehicles. Unlike the vast majority of mutual funds, however, ETFs have both a primary and a secondary market. The primary market for ETFs is made up of Authorized Participants (APs). APs play a similar role to traditional “market makers,” but unlike market makers, they are not obligated to take a counterparty position on a trade whenever an investor seeks to acquire or offload shares (more on that in a moment). The secondary market for ETFs is made up of both retail and institutional investors who can trade ETF shares on registered exchanges on an intra-day basis.
  • The issuing process for ETFs typically involves an “in-kind” exchange between the fund and an AP. The fund issues a “creation unit” to the AP in exchange for a particular basket of securities. The redemption process typically involves the same “in-kind” exchange, only in reverse.
  • After a creation unit is issued to an AP, the AP can either hold the investment, or sell shares to investors in the secondary market. ETF share price in the secondary market is influenced by supply and demand, but tends to remain close to net asset value or NAV (total value of fund divided by total number of shares). This is because, when share price deviates from NAV, it presents an arbitrage opportunity for APs, which the APs generally exploit, causing supply and demand to balance out and share price to move back towards NAV. For example, if excess supply in the secondary market has driven share price down below NAV, an AP will take advantage of that price discrepancy by redeeming shares from investors and tendering creation units to the fund. The AP profits from this transaction because it purchases ETF shares from investors for less than NAV, then tenders the shares to the fund (in creation units) in exchange for NAV. The liquidity supplied by the AP causes the ETF share price to rise back to NAV.
  • As mentioned above, ETF investing is often considerably less expensive than mutual fund investing. There are several reasons for this. First, most ETFs are passively managed index funds, whereas most mutual funds are actively managed by fund managers who charge substantially higher management fees. Second, many mutual funds charge “12b-1 fees” to cover advertising and distribution costs and “sales loads” (a percentage of the investment) to pay for brokerage services. In comparison, ETF investors do not pay 12b-1 fees and typically pay fixed commissions, usually $8 to $10 per trade. For the typical buy-and-hold investor, this makes ETF investing considerably more economical than mutual fund investing. Third, mutual fund redemptions are cash transactions, as opposed to “in-kind” redemptions. In order to raise the cash needed to satisfy redemption requests, mutual funds are often forced to liquidate holdings. This can result in capital gains to the fund, which trigger tax liabilities.

Risks Associated With ETF Investing

  • There have been several instances of extreme short-term volatility in the ETF market. A recent example was the August 24, 2015 “flash crash,” which saw ETF share prices plummet well below NAV before recovering almost as quickly. While the stock market also suffered significant losses that day, the ETF market was hit significantly harder. Some ETFs lost more than 45% of their value. For most buy-and-hold investors, this type of short-term volatility is not a major cause of concern. However, a significant number of buy-and-hold investors were damaged by the August 2015 flash crash due to stop-loss market orders going into effect. A stop-loss market order is a standing instruction to a broker to sell a security when its price declines to a certain level. On August 24, 2015, stop-loss market orders on ETF holdings went into effect in a rapidly declining market, which meant that by the time the orders executed, the price was substantially lower than the stop price.
  • Following the August 24, 2015 flash crash, the Wall Street Journal reported that “Lansing, Mich.-based financial adviser Theodore Feight had set up an automatic sale for iShares Core U.S. Value ETF IUSV -0.02 % if it were to fall a certain amount.” According to the article,  “[t]he ETF tumbled 34% in early trading, and instead of Mr. Feight’s position selling at his target price of $108.69, down 14%, it sold at $87.32, off 31%.”
  • The extreme volatility in the ETF market on August 24, 2015 was the result of short-term illiquidity in the market for certain stocks, caused by trading halts that went into effect under so-called “circuit-breaker” rules. The temporary halts in trading made it impossible to determine the NAV of the ETFs that were exposed to the affected stocks. As a result, APs could not accurately gage the existence of arbitrage opportunities, and were only willing to supply liquidity at (what would prove to be) extremely discounted prices.
  • Some market commentators contend that there was still “liquidity” in the ETF market during the August 2015 flash crash, but that contention appears to be based on a narrow definition of liquidity that only considers trading volume and ignores price continuity (the ability to trade at prices that reflect recent bid and ask prices).
  • The flash crashes that have affected the ETF market have led to speculation that a crash of greater duration could materialize if a situation arises where a significant number  of constituent underlying securities (e.g., bonds) enter a sustained period of illiquidity (i.e., something more than a temporary halt in trading). If the market for the constituent underlying securities were to become so illiquid that the APs could not accurately gage NAV, the APs would presumably be unwilling to supply liquidity to the ETF market, except in the narrow sense that they might be willing to buy ETF shares at distressed prices. Such a scenario would obviously impact any investor whose investment time horizon coincided with the liquidity crunch. Those with longer investment time horizons would not necessarily be spared. For example, those with securities-backed loans, or trading on margin, might find themselves faced with collateral  calls or margin calls.
  • As the popularity of ETFs has grown, so has the availability of complex, high-risk ETFs. Leveraged and inverse leveraged ETFs are a prime example of that. These “non-traditional” ETFs are designed to be short-term trading vehicles, not suitable for holding overnight, and generally not suitable for conservative and moderate investors. However, that has not stopped unscrupulous or uninformed brokers selling non-traditional ETFs to conservative retail investors. Recently, regulators have been clamping down on such behavior. For example, FINRA recently imposed a $2.25 million fine on Oppenheimer & Co. for unsuitable sales of non-traditional ETFs. Many brokerage firms are now prohibiting their brokers from recommending shares of leveraged and inverse leveraged ETFs to retail customers.
  • Leveraged ETFs are designed to be more volatile, on a daily basis, than a designated index or benchmark, usually by a leverage facto of X2 or X3. For example, a X2 leveraged ETF that corresponds to gains and losses in the S&P 500 would give the investor twice the volatility of the S&P 500. So, if the S&P 500 were to gain 10% on any given day, the ETF would gain 20% on that day. Inverse ETFs react inversely to a given index or benchmark and can also be levered.
  • What many investors fail to appreciate about leveraged ETFs, and are never told by their brokers, is that the investments can perform remarkably badly in volatile markets, even when there is no net gain or loss in the applicable index or benchmark. This is due to the effect of daily resets and compounding. A simple example illustrates the risk. Assume investor A invests $100 in a X2 leveraged ETF that corresponds to gains and losses in the S&P 500 and assume investor B invests the same amount in a traditional ETF that simply tracks the S&P 500. Assume the S&P 500 gains 10% in value on day one. Investor A’s investment would rise to $120, while investor B’s investment would rise to $110. Assume the S&P 500 declines by 9.1% on day two. Investor A’s investment declines by 18.2% or $21.84, resulting in a net loss to the investor over two days of $1.84. Investor B’s investment declines by 9.1% or $10, resulting in no net loss or gain.  If this process is repeated several times over, the effect of compounding can quickly lead to huge losses in the leveraged ETF.
  • Geared (Short or Ultra) ProShares ETFs are an example of leveraged and inverse leveraged ETFs. ProShares website discusses the compounding risk associated with leveraged ETFs as follows: “Due to the compounding of daily returns, Geared ProShares’ returns over periods other than one day will likely differ in amount and possibly direction from the target return for the same period.”