Exchange traded funds (ETFs) have seen record inflows this year, with assets in bond ETFs skyrocketing to a new record high, but concerns are now emerging that these instruments could be exacerbating market volatility in times of stress, and the US regular has already waded in.
Assets in bond ETFs have ballooned past the $600bn mark by the end of September, with some $100bn of inflows marking a 24% growth in assets since the end of 2015, when they stood at $495bn, according to BlackRock. Since 2007, assets in global bond ETFs have risen ten-fold, from just $60bn.
These flows do not seem to be slowing down, either. Data from Lipper for September revealed fixed income ETFs domiciled in Europe saw the largest net inflows in September of all asset classes, taking in €1.3bn, with a large chunk of this going into emerging market debt.
But it is not only bond ETFs that have enjoyed inflows this year. Smart-beta ETFs are also taking in record amounts of money, with assets in European-domiciled products expanding to $30bn this year, a 40% increase on 2015.
Global ETF assets have jumped from $1.5trn in 2010 to $3trn at the end of last year, according to PwC, with the firm expecting the size of the industry to rise as high as $8trn in assets by 2021. Assets for ETFs and ETPs listen in Europe have also reached a new high of $567bn at the end of Q3, ETFGI reports.
In short, the industry is booming, but this is unsettling regulators and investors alike, who are claiming market volatility is being exacerbated by the sheer volumes of money being traded in and out of ETFs.
There is no need to go far back in time to draw on examples where ETFs have been hit by market volatility. For example, during the ‘Black Friday’ sell-off on 24 August 2015, when Chinese shares saw steep falls dragging down other global stock markets, more than 1,000 US-listed securities were suspended from trading after sharp moves in their equity prices, while some ETFs saw violent swings in their net asset values.
Meanwhile, bond ETFs are coming under particular scrutiny, as worries grow over a potential sell off in bonds across the globe as a response to rate increases in the US and a shift of focus away from monetary to fiscal expansion in various economies.
Fitch Ratings issued a report last week warning about bond liquidity, as the ratings agency expressed concerns bond funds could not withstand a major sell-off. High profile investors, such as billionaire Carl Icahn, have also voiced their concerns, saying these vehicles have not yet been tested by a mass exodus from the market.
At the same time, there are already signs investors are turning away from bonds, with EPFR reporting outflows of $727m from local currency emerging market debt during the week ending 19 October, while yields on government bonds in developed countries have been on the rise as investors sell out.
All these issues are now being investigated in the US by the Securities and Exchange Commission (SEC), which last week announced it had launched a large-scale investigation into the ETF industry.
The US regulator already got its hands on leveraged ETFs earlier this year, with worries emerging that these products can easily lead to high losses if the leverage ratio is too high. The SEC has proposed a ruling to cap the leverage on a fund to 150% of its net assets to limit this volatility.
It remains to be seen what the outcome of the latest investigation will be, but for now this is focused on the US only. Yet no doubt European regulator will also be compelled to act if the SEC finds failings and liquidity threats as a result of its review.