One area of financial markets where ETFs could prove very disruptive

Some people argue that ETFs undermine the structure of the stockmarket. That’s not really true, says John Stepek. But they could spark trouble in another area of the markets.

180521-etfs

ETFs don't pose an existential threat to the stockmarkets

Large chunks of the finance industry mainly those whose business survival depends on investors continuing to overpay for underperformance don't much like exchange-traded funds (ETFs) or other forms of "passive" investment.

So they spend a lot of their time trying to attack them in various ways.

One line of attack is to argue that ETFs are in some way undermining the structure of the market a bit like CDOs and other obscure derivatives helped to trigger the 2008 financial crash.

I love a good disaster story, but I have to say that I have struggled to find a convincing argument on the dangers posed to the stock market by ETFs.

However, there is one area where I suspect that ETFs could play a more disruptive role.

It's hard to see why stockmarket ETFs would be aparticularly big problem

More and more of the money piling into global stock markets is getting there via ETFs.

By and large, these funds just track an underlying market. You can argue that these are momentum trades just chasing the market higher. And you can argue that they're not very selective you buy the market, you don't do any analysis on the underlying companies.

But it's hard to make those arguments stick when the alternative investing in an "active" fund that tries to beat the market generally doesn't manage to beat the ETF.

Moreover, when it comes to ETFs connected to the major stockmarkets, I find it very hard to see where the major systemic problem would arise (although I am open to suggestions, as always).

The world's major stockmarkets the ones which are most heavily invested in are very liquid. Even in panicky times, you will be able to sell. You might not like the price you get but you'll get a price.

It's hard to see how ETFs have changed that very much. An S&P 500 tracker, for example, is really just a cheaper way of executing a trade that an ostensibly "active" fund manager used to do for you.

The fact that ETFs reduce the trading friction they're fractionally easier than an open-ended fund to buy and sell at the push of a button might have some effect. If investors panic and bail out, then you might find that the quantity of money invested via ETFs means that swings become more volatile.

In other words, you could argue that ETFs may have contributed to a rise in the quantity of jittery "hot" money sitting in the markets. Combined with the rise in algorithmic trading, that gives you a recipe for more exaggerated moves during times of stress.

But that doesn't really feel like a qualitative change in markets. It's not the sort of thing to cause a 2008-style freeze. It's more likely to cause a 1987-style crash, if anything short, sharp and scary, but ultimately caused by everyone betting in the same direction much more aggressively than they'd all realised.

I'm not saying that a repeat of 1987 would be fun. But it's not really new, and it's also relatively easily resolved you get a crash and then you get a rebound.

Watch out for stresses in the corporate bond market

What looks like far more fertile ground for stickier problems is the corporate bond market.

As Louis Gave of Gavekal research points out, corporate bond ETFs have funnelled lots of retail investors into a sector that was once largely institutional. So unlike in equity markets ETFs have introduced a whole new set of players who are not necessarily familiar with the ups and downs of this market.

On top of that, new rules introduced after the 2008 financial crisis have discouraged banks and other bond-dealing institutions from sitting on inventories of bonds. That makes it harder to ensure that there is always a buyer in the market in times of stress. In other words, it makes the market less liquid.

Meanwhile, on top of this, over time, the quality of corporate credit has declined dramatically. There's a very good reason for that. There has been lots of money available to borrow cheaply. In turn, that means borrowers can access cheaper loans, on less stringent conditions.

But when lending conditions are good for borrowers, that means they are bad for lenders. Lenders are taking on more and more risk, for ever-lower returns. That can't last.

In sum, we have a market freshly filled with relative newcomers; liquidity in this market is, at least, not as good as it was; and the market itself is, by any objective standard, much more vulnerable to nasty surprises than it has been in the past.

That sounds more like a recipe for trouble to me.

The thing with ETFs is that you expect to be able to trade them at any time. So a panic in the corporate bond market triggered by a combination of rising defaults (as interest rates rise), the relative inexperience of the participants, and the drying up of institutional liquidity could be a lot more disruptive than a similar panic in the equity markets.

I don't know if it likely to happen any time soon, but inflation is bad for bonds and rising interest rates are bad for bonds. Solid economic growth should mean that half-decent companies can thrive despite tighter monetary conditions, but not all of these companies are even half-decent.

All of these things are happening now. So I'll be keeping a close eye on the corporate bond market for signs of stress.

Just to be clear this isn't the "fault" of ETFs as such. The real issue is that they risk making an already vulnerable-looking situation even trickier if and when it all kicks off.

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