Could the next financial crisis come from the over $3trillion ETF and index market? Could the trend – heavy use of ETFs – lead into the next structured product debacle? Are these trackers, prone to becoming dangerous trucks with no breaks, ready to collide in the next unexpected turn of the market road?

Fintech has undoubtedly contributed to the growth of the industry and Vanguard’s philosophy is no questioned. It is part of any and every portfolio, to a small or large degree. ETFs have become mainstream but this means that investors are not asking any more questions about the risks they are exposed to. ETFs are stereotypes for low cost, liquid, and tax efficient vehicles to gain exposure to a country, a sector, or an investment theme.  They are seen as the efficient way to execute and they often provide investors with the illusion that they outsmarted the financial professionals acting as intermediaries and offer financial advisory services. I will agree with all of the above stereotypes; only partly. The risks lurking should be understood and kept in perspective.

ETF risks

The Investment theme risk, is understood by all investors; which country, asset class, industry sector, style, one chooses to invest in.

The Tracking risk, is usually understood; how well does the selected ETF track the investment space promised.

The cost risks, can include, tax implications (commodity and currency ETFs need caution) and costs related to ETF closing procedures (e.g. Blackrock closed in 2014 as many ETFs as it opened – Lists of announcement for closures of ETFs can be found from ETF.com, here). There is a behavioral cost that I see as becoming more significant through the digitization of financial services that has been undervalued. It is the fact that ETF usage has increased not only in passively managed discretionary mandates (through first generation robo-advisors) but also in DIY and actively managed accounts. This results in using low cost financial vehicles, ETF, but incurring OVERTRADING costs.

The liquidity risks, are more complex than at first site.

There are ETFs that target illiquid markets (e.g. equity exposure to Nigerian stock market; or specific bond market).

There are ETFs that simply don’t accumulate enough volume and therefore the bid/ask spread is wide. This is because the market maker (e.g. Virtu Financial) is dealing with a narrow market. There are tons of ETFs that are low volume (close to 30% are reported to trade less than 5,000 shares per day!). Exchanges are giving out incentives to the trading firms involved in market making, to keep these structures alive (August announcement by NASDAQ). BATs is incentivizing ETF issuers by paying them to list on BATS.

There is also the Premium/Discount spread that reflects whether the ETF itself is trading above or below the NAV of the underlying portfolio. This can happen because of behavioral trends (i.e. the crowd pilling into an investment theme or an investment theme gapping down because of an event that turned it out of favor). This is the type of risk that Betterment tried to protect its clients from, when it halted trading during the aftermath of the Brexit (Covered in the conversation on the Fintech Genome, here).

The last and least understood, liquidity and counterparty related risk, is one related to the Creation/Redemption process of ETFs. This is actually the secret sauce of these structures, that gives them the intraday liquidity which is lacking from mutual funds and the tax efficiencies. The Creation/Redemption process of ETFs refers to how the shares are created or redeemed. The process is complex and if one wants to understand it, it is explained on ETF.com here. The hidden risk that needs light shed onto it, is related to Authorized Participants (APs) who are the entities that create and redeem ETF shares and are sometimes the same as market makers; but not always. They are the usual suspects (large broker dealers) and have signed AP agreements with the ETF issuers (see a SEC registered AP agreement here). In summary, for each ETF, one has to think of the Issuer (e.g. Vanguard, Blackrock), the Authorized Participant AP (DTCC reports that there are currently 50 AP firms) and the Market Maker (e.g. ), and the Custodian (e.g. JP Morgan, State Street).

Source: Vangaurd learning

So, one can say that at least Four kinds of liquidity risks are inherent in ETFs. The AP related risk or the risk inherent in the “magic” Creation/Redemption process of ETFs; can become one that makes the speeding ETF truck to derail. It is a risk that cannot escape from a Lehman moment in the financial sector. Even if one invests in an ETF that has no direct exposure to the financial sector, through the double liquidity dependence on Authorized Participants and Market Makers of ETFs, the risk is there and real. In august 2015 when the market gapped, ETF prices were not available and active investors, those needing to hedge through ETFs; were facing a void. Passive investors focused on mirroring Indices, were dissapointed too. Panic and behavioral biases, can turn a seemingly well functioning market into one that is illiquid, volatile and distorted. All these factors are concentrated in the financial sector. There is no difference from the time of the mortgage strcutured products crisis and the out of proportion domino effect.

Daily Fintech Advisers provides strategic consulting to organizations with business and investment interests in Fintech & operates the Fintech Genome P2P Knowledge Network.  Efi Pylarinou is a Digital Wealth Management thought leader.