ETFs are funds that track a stock index, bonds or commodities. In contrast to mutual funds, exchange-traded funds are not actively managed, since their policy is only to reproduce the same diversification of a particular index.[1]
Investors in these open-end funds pursue a passive investment strategy. Banks usually offer two different types of ETFs, which both have the same purpose. One is a physical ETF which holds the same amount and allocation of stocks of the underlying index. The other is a synthetic ETF that tries to replicate with financial instruments the equity market e.g. S&P 500 through swaps to achieve the same amount of return.[2]
Figure 1 – the Global growth of ETFs – Source: Financial Times (2017)
Figure 1 portrays the global growth of ETFs from the year 2015 to 2017. Over the last ten years, a steady increase can be noticed. Even Larry Fink, leader of the biggest Investment management corporation and biggest provider of ETFs, BlackRock, has predicted a rise up to $400bn in the next decade.[3]
Due to this very high demand, there is a strong interest on the part of the banks to expand their offer of these kinds of funds.
Disadvantages
A difficult matter for banks is to replicate an index as close as possible. Especially in physical ETFs as weighing of stocks in an index may change. This might be the case when a company issues new equity or a company joins or leaves the index. As a result, the index must be adapted again and again. For large indices, e.g., MSCI World, which consists of more than 1600 shares is a 1 to 1 replica almost impossible.[4] Financial Institutions tend to buy a comprehensible number of individual stocks to replicate the development of the underlying market. This increases the probability of a tracking error, and the ETF could perform worse than the market index.
Figure 2 - ISHARES CORE S&P 500 UCITS ETF USD – ACC (yellow) & S&P500 Index (blue) – Source: Comdirect Bank (2018)
Figure 2 illustrates the performance of a physical ETF and the underlying S&P 500 Index. Noticeable is the distinction between year 2011 and 2015, where the ETF was outperformed by the S&P 500. A clear proof that banks have difficulties in replicating.
Since most investors require a certain amount of security, there is a hitch with physical hedge missing for synthetic ETFs. In this case, there is counterparty risk. If the latter happens and a bank goes bankrupt, investors might struggle to get their money back. Because of this, most market participants shy away from spending a huge amount of money on such ETFs. For this reason, the bank has to hedge them with derivatives or put assets aside which, however, cause costs.[5] To get an additional return, banks lend these assets to get some revenues. This is compounded by another counterparty risk. Due to the high competition among global banks, they tend to reduce the cost of ETFs which results in increased risk.
Advantages of ETFs
Apart from the disadvantages, it is important to note that ETFs act like indexes meaning they can easily follow a certain market sector. However, as compared to indexes, ETFs are purchased with a single transaction where an investor purchases a single portfolio and not a basket of stocks[6]. In which case, it is always beneficial to investors in the event of targeting a given price.
Given the fact that ETF market has rapidly grown in the past five years, it is evident that investors value the fact that ETFs have low management expense ratios as well as the liquidity of an exchange-traded product[7]. Additionally, most ETFs have what is referred to as a passive investment strategy where they follow their respective investment strategy. For instance, an investor who compares the returns of iShares S&P/TSX index which is the most common physical ETF in Canada with S&P/TSX60 index, it is evident that the iShares tend to deviate from their benchmark by only 1.2% over a period of 5 years[8]. In which case, ETFs allow passive management where they are allowed to follow a given benchmark but not to exceed them as opposed to managed fund that looks at high return than the underlying assets.
Figure 3: Illustrates how the passive physical ETFs closely track the return on the underlying assets.
Conclusion
ETFs have gained popularity in the banking industry as they are able to generate significant benefits for investors. Consequently, they are able to provide passive management, low-cost portfolio, and single transactions. However, they have also brought several risks or rather demerits that could have negative effects on the banking industry. In which case, the markets from which ETF assets derive their value might be less liquid since there is over-reliance on the authorized participants. Furthermore, Synthetic ETFs tend to pose collateral and counterparty risks that might trigger investor run which can impact assets markets in case the risks materialize. In that connection, it is proper for the investors to conduct in-depth research into ETFs and make the right decisions that would not affect them in the long run. On the other hand, with increasingly rapid changes in the market, it is appropriate for the relevant authorities to monitor its development closely.
Bibliography
Financial Times (2010) – URL: https://www.ft.com/content/44f0b7b6-0cce-11df-b8eb-00144feabdc0
Financial Times (2018) – URL: https://www.ft.com/content/f66b2a9e-d53d-11e8-a854-33d6f82e62f8
Financial Times Lexicon – URL: http://lexicon.ft.com/Term?term=exchange-traded-funds--ETFs
Foucher, I., and Gray, K., 2014. Exchange-traded funds: Evolution of benefits, vulnerabilities, and risks. Bank of Canada Financial System Review, pp.37-46.
Kennedy, Mark. 2018. “9 Reasons ETFs Can Benefit Your Portfolio.” The Balance Small Business. The Balance. https://www.thebalance.com/nine-reasons-etfs-can-benefit-your-portfolio-1214711.
MSCI World Index (2018) – URL: https://www.msci.com/documents/10199/178e6643-6ae6-47b9-82be-e1fc565ededb
Vanguard (nd): https://advisors.vanguard.com/VGApp/iip/site/advisor/etfcenter/articl e/ETF_PhysicalSynthetic
[1] Vanguard - URL: https://advisors.vanguard.com/VGApp/iip/site/advisor/etfcenter/article/ETF_PhysicalSynthetic
[2] Financial Times Lexicon – URL: http://lexicon.ft.com/Term?term=exchange-traded-funds--ETFs
[3] Financial Times (2018) – URL: https://www.ft.com/content/f66b2a9e-d53d-11e8-a854-33d6f82e62f8
[4] MSCI World Index (2018) – URL: https://www.msci.com/documents/10199/178e6643-6ae6-47b9-82be-e1fc565ededb
[5] Financial Times (2010) – URL: https://www.ft.com/content/44f0b7b6-0cce-11df-b8eb-00144feabdc0
[6] Kennedy, Mark. 2018. “9 Reasons ETFs Can Benefit Your Portfolio.” The Balance Small Business. The Balance. https://www.thebalance.com/nine-reasons-etfs-can-benefit-your-portfolio-1214711.
[7] Foucher, I. and Gray, K., 2014. Exchange-traded funds: Evolution of benefits, vulnerabilities and risks. Bank of Canada Financial System Review, pp.37-46.
[8] Foucher and Gray, Exchange-traded funds: Evolution of benefits, vulnerabilities and risks
