On first examination, exchange-traded funds (ETFs) are a good thing, and the reason for their popularity is obvious: they not only offer instant liquidity, but also lower costs.
In a study conducted two years ago, Kenneth French, professor of finance at Dartmouth College’s Tuck School of Business, estimated that mutual funds’ active money managers ‘cost US investors no less than $80 bn a year – with no commensurate return over ETFs.’ Since then investors’ money has flooded toward ETFs that guarantee to meet indexed expectations, without the high charges. BlackRock estimates inflows of $67.2 bn into the funds in 2011, and most analysts expect the growth to continue.
It is typical of the finance sector that what started off as such an eminently sensible product should begin to get the iridescent tinge of a bubble, as financial institutions work out how to make money from it.
ETFs’ original assurance of representing direct holdings of the stocks in an index has been diluted, particularly in Europe. A recent report from the Financial Stability Board (FSB) has rung a warning bell about the rapidly evolving sector. The FSB, estimating $1.2 tn in ETF holdings in 2010 Q3, warns that even at this early stage ‘the speed and breadth of financial innovation in the ETF market has been remarkable... and has brought new elements of complexity and opacity into this standardized market.’
It also points out that ‘synthetic ETFs obtain the desired return through entering into an asset swap – such as an over-the-counter derivative – with a counterparty instead of replicating the index physically’ and adds that ‘some ETF providers are said to generate more fee income from securities lending than from their traditional management fees. Since securities lending is a bilateral collateralized operation, it may create similar counterparty and collateral risks to synthetic ETFs.’
Nor is the FSB alone in sounding a note of caution. On the macroeconomic scale, corporate governance activist Bob Monks suggests that, apart from other risks associated with ETFs, the funds represent a potentially dangerous extension of indexation into the markets. Estimating that ‘ETFs, indexes and ‘closet indexers’ among mutual funds already make up about 40 percent of the market, I’m told that if you get up to about 60 percent, there really is no market anymore,’ he points out.
While French is sure ‘we have a long way to go before there are not enough active investors’, Dr Konstantina Kappou of the ICMA Centre Henley Business School in the UK concurs with Monks. ‘There is definitely an issue with the increase of passive management in capital markets over the last decade,’ she says.
‘In simple terms, if all active traders who are responsible for eliminating market inefficiencies in stock pricing disappear from the market and all we are left with is a considerable amount of indexed money handled by purely passive portfolio managers, one could argue about an increase in market volatility and misleading stock valuations.’
Kappou notes approvingly that ‘the FSB report covers all the major concerns about the recent increase in the variety of ETFs and the complexity of some exchange-traded vehicles. The regulation process needs to progress along with the market developments to protect the average investor, especially in the case of less liquid ETFs.’
Weights and measures
Closer to corporate home, ETFs could exacerbate the index effect Kappou and her colleagues in the UK have already measured. ‘Our results, after examining S&P 500 additions, show there is a permanent
positive effect on the stock price of around 5 percent, and a significant increase in the stock’s trading volume during the event period,’ she notes.
‘The opposite effect occurs for deletions, providing evidence that index changes are not information-free events. The more money is tied to the index, the more index portfolio managers will be involved in trading the underlying stocks around the index recomposition, causing abnormal return shocks. Being added into an index may result in the stock being ‘monitored’ by a higher number of analysts and being ‘recognized’ by a higher number of investors, whereas being deleted from an index incorporates the risk of being ‘shadowed’ even if nothing has changed fundamentally.’
Sal Gilbertie, president of ETF sponsor Teucrium Trading, warns of another overlooked problem for investors. ‘They could be weighting their portfolios incorrectly, because they might buy an ETF that includes Ford, and yet hold Ford separately, which puts them overweight in that stock,’ he explains. ‘The biggest danger is people not understanding the composition of their holdings.’
On the other side of the corporate fence, IROs seem to neglect ETFs, particularly those based on customized indexes. ‘We’ve had investors come to us and say they’d like certain companies included, but we’ve not had any companies come to us themselves for inclusion,’ Gilbertie admits. ‘Although sometimes companies have approached us to design a product to help them with their operations – for example, grain firms with large stocks that want Teucrium to develop an investment product for those stocks.’
On the macro level, Gilbertie’s experience is that ‘investors are trading sectors more than individual stocks: if someone likes autos, then it might be better to bet on the whole sector rather than pick one and risk being wrong.’
Jeff Fancher, IRO at AT&T – which is, of course, on all the indexes – says, ‘I still talk regularly to all our major institutions. The issue of double-dipping ETF and direct holdings has never come up so, in terms of IR practice for us, it has no effect.’
Smaller companies might not have the security of a giant like AT&T, however. ETFs are moving beyond simple value-based indexes and becoming more refined. Jon Lukomnik, executive director at IRRC Institute, points out that ETFs tend to proliferate into more specialized indexes.
‘If you are an ETF that invests in a particular industry, you can hold 3 percent to 5 percent of a company,’ he explains. ‘With a micro-caps ETF, you can have a major institution holding large stakes in firms that traditionally have a retail shareholder base, so if a sector ETF owns you and it becomes hot or cold, you have the wider swings of the marketplace.’
He also points out certain implications of indexing that IROs and corporate secretaries overlook: while active trading in ETFs might have unforeseen effects, the extension of indexing they represent also has implications for governance. Indeed, Lukomnik credits the original growth of indexation with the genesis of the modern governance movement. ‘The turnover of the S&P used to be every seven years and mutual funds 11 months,’ he notes. ‘I don’t know now, but I can guarantee an index fund is a longer-term holder than the average active mutual fund.’
While mutual funds provide market and price discipline, Lukomnik says ‘indexes provide active ownership discipline: where you can’t use exit, you use voice.’
In other words, while holders of ETFs have no control over which stocks they hold, they can exercise some control by engaging with the companies held by the ETF and ensuring they know when shareholders are unhappy with governance practices.
With ETFs, the corollary is that ‘small active funds can improve the [governance] situation and outperform,’ Lukomnik continues. ‘In the old days, holders used to pass through the proxies. ETFs vote them, and they have become major holders and voters. By the time you get to specialized ETFs, they can hold a significant portion of a company, and IR professionals and corporate secretaries need to have them on their radar screen.’
Taken together, there are warning signs aplenty for regulators, investors and companies, which is hardly anything new. The factors that brought about the tech bubble, the collateralized debt obligations crash and the rest are being replicated with ETFs: floods of cash and tidal surges of ingenuity in the markets advancing faster than the regulators’ event horizon.
The FSB report deserves more attention on the macro level, and IR and corporate governance professionals might want to check their own assumptions against the changing investor universe, and look back to a decade or so ago when they discovered their hedge fund stakes only when they were being sold.