ETFs: the new star product of financial markets

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September 9th, 2015

Exchange-traded funds (ETFs) are one of the most remarkable financial innovations of recent years. Their rise has been meteoric, leading to questions regarding their implications for the global financial system, both in terms of efficiency and stability. On the whole, the pros outweigh the cons.

ETFs are investment funds whose shares are traded on a stock market just like other equity. An ETF invests in many kindd of assets (bonds, shares, commodities, property, etc.) and investors can buy or sell their shares at any time while the stock exchange is open. This distinctive feature (which gives rise to their name) comes in addition to another feature (which has given them their reputation): they track a specific index and investors therefore earn the returns associated with this index (be it shares, bonds, currency or other assets, or a combination of these).

Their high liquidity and passive management make ETFs considerably attractive. Firstly, trading is immediate: albeit with a fiscal penalty, investors can buy and sell their shares via the internet with immediate effect, even on foreign exchanges, and minimum deposit requirements tend to be modest (between 0 and 600 euros). Secondly, they are low cost as management fees are lower than for ordinary investment funds and hedge funds. Thirdly, their risk-return profile is simpler: the investment strategy and assets selected by each ETF are well-known by investors, unlike the discretion given to managers of ordinary (actively managed) funds and hedge funds. Fourthly, they are flexible and versatile: the brochure of available ETFs covers an incredibly wide range of assets and strategies. The first, and best-known, are beta ETFs, which track an index whose components are weighted by market capitalisation (for example, the Ibex 35). Beta+ ETFs also track the return offered by an index but amplified long (leveraged ETFs) or short (inverse ETFs). Smart beta ETFs provide exposure to more elaborate strategies such as value or growth investing and small caps, applying a range of additional criteria to weigh assets. Lastly, alpha ETFs offer passive management but with the aim of beating the market's returns by applying criteria to select assets and manage portfolios that are related to identifying general macro-financial trends and cycles or to choosing specific actions (such as price momentum).

Thanks to these features, ETFs have enjoyed great commercial success among both individual and institutional investors. After enjoying 28% annual growth on average since 2003 the more than 1,400 ETFs available worldwide amount to around three trillion dollars. They have already outstripped hedge funds although they still have a long way to go to catch up with ordinary investment funds.

With regard to the efficiency of the financial system as a whole, ETFs make a positive contribution: they provide access to markets, assets and strategies that were previously remote or restricted to specialists, helping all kinds of investors to broaden their portfolios (including low volume individual investors) and to adjust the risk profile to their own particular preferences. Given their flexible supply and the fact that, ultimately, they reflect the prices of their underlying assets, ETFs should not hamper the correct functioning of market prices nor should they distort the efficient allocation of resources to such assets. Moreover they reduce the financial brokerage costs paid by investors.

However, the impact of ETFs on financial stability is not so clear-cut. Specifically, their high liquidity is a double-edged sword. Liquidity fulfils a different role in ETFs than in the case of shares as it depends on their underlying assets and the issuer's capacity to generate and suppress shares according to demand. This makes ETFs highly flexible and their price is much more affected by the price of their underlying assets than by their own supply and demand. But there are concerns regarding what might happen in the case of a fire sale: ETFs could accelerate and amplify sales, especially leveraged ETFs. Fortunately, international regulators and supervisors are aware that this risk requires regulation, vigilance and, if necessary, action.