Commentary

ETFs and the beguiling promise of diversification

Do 'low-risk', low-volatility exchange-traded funds expose investors to far greater risks?

As a young science fiction writer, L. Ron Hubbard, the founder of Scientology, was reported to have saidthat if a man wanted to get rich he should invent his own religion. In the world of financial markets, Mr Hubbard's observation could be recast: To make serious money on Wall Street you have to invent an asset class.

The history of modern finance has been defined by these innovations, and each has arrived with a compelling justification for why investors should embrace them. In the 1980s, Mr Michael Milken ram-raided the established order of United States banking armed with a powerful new tool, the high-yield bond. Two decades later, salesmen of structured credit products arrived in the offices of pension funds with bold claims of having radically altered the nature of credit risk.

Diversification is one of the most powerful sales tools in finance. If investors can be convinced that a dazzling new product is now a permanent feature of financial markets - an asset class - then the rules of diversification dictate that they must begin buying it. As with all financial innovations, there is the worry that investors begin to buy into products with risks they do not fully understand.

When historians look back on the post-2008 era, the innovation that will probably define it will be the explosive proliferation of new financial products tied to a singularly powerful idea: passive investment. We are fast approach- ing a world where asset- allocation decisions are defined by a single dichotomy: the choice between "active" investment based on some form of human judgment and "passive" funds that track a broad section of the market, usually based on an index such as the S&P 500.

"Passive investment" has been transmuted from an intellectual debate over investment practice into a justification for trillions of dollars of financial products to be sold. The purity of an idea, however, is not always reflected in the products that are marketed in its name. A process that began as a much-needed criticism of the excesses and failures of the mutual fund industry is now starting to take on some of the characteristics of the new "asset classes" that came before - namely complex risks whose correlations to each other are hard to model.

Diversification is one of the most powerful sales tools in finance. If investors can be convinced that a dazzling new product is now a permanent feature of financial markets - an asset class - then the rules of diversification dictate that they must begin buying it. As with all financial innovations, there is the worry that investors begin to buy into products with risks they do not fully understand.

In 2008, the year of the collapse of Lehman Brothers, there was US$772 billion worth of assets invested in exchange-traded products, according to data from BlackRock. There is now over US$3 trillion (S$4.2 trillion)worth of assets invested in more than 6,000 of these products, with exchange-traded products (ETPs) having become the main engines for the passive investment revolution.

ETPs are meant to provide investors with liquid and diversified exposure to an underlying investment, be it US equities or Asian corporate debt. There is a concern that some of these products are concentrating risk rather than dispersing it.

Exchange-traded fund (ETF) providers compete on scale, charging very low fees for their products. As a result, there is a strong commercial incentive to design and create ETFs that have the ability to achieve a large enough scale to be commercially viable. This, in turn, incentivises providers to build their products around large-capitalisation stocks.

Mr Steven Bregman of Horizon Kinetics, a New York investment adviser, has noted that many index-tracking ETPs are far less diversified than one might imagine.

The iShares US Energy ETF, for example, holds 50 per cent of its assets in the shares of just four energy companies. Are investors who hold this ETF aware that they have taken on such concentrated exposure?

Another thing Mr Bregman has observed is the seemingly bizarre way the models that run certain "factor-based" ETFs that invest in less volatile shares have wound up putting large amounts of their assets into financial services stocks - not a sector traditionally viewed as low risk. The SPDR Russell 1000 Low Volatility ETF holds 36 per cent of its assets in financial services stocks. Another, the PowerShares S&P SmallCap Low Volatility ETF, has nearly half of its assets in financials. As Mr Bregman says: "Would an active manager of a low-risk strategy be permitted the risk of a near-50 per cent weighting in financials?"

We do not yet know if supposedly "low-risk", low-volatility ETFs are exposing investors to far greater risks. Are they damned by design to be invested in the shares they hold precisely until their volatility increases, which is when they become forced sellers? As Mr Bregman says: "Would anyone legitimately assert that these ETFs (holding large amounts of financials) will remain non-volatile if rates rise? The ETFs can't trade out of low-beta securities, but they can once the beta rises."

The complexity of another small sub-section of ETPs called exchange-traded notes is also a worry. These have been marketed to retail investors as providing a liquid means of gaining exposure to an underlying asset, with about US$20 billion of these notes outstanding, according to Morningstar. The notes are, in fact, unsecured debt issued by investment banks, meaning an investor is not only taking on the risk of the asset they track but also the credit risk to a financial institution. Some banks have already stopped issuing them.

US regulators, with the last crisis very much on their minds, have moved to review the ETF industry in the knowledge that these products were at the centre of wild price swings in August last year. Given the strong correlation between innovative new products and financial crises, we can only hope that maybe, for once, this time it will truly be different.

THE FINANCIAL TIMES

A version of this article appeared in the print edition of The Straits Times on November 07, 2016, with the headline 'ETFs and the beguiling promise of diversification'. Print Edition | Subscribe