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Growth of ETFs may pose hidden risks for markets

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Growth of ETFs may pose hidden risks for markets

With assets in exchange traded funds more than tripling to $4.4 trillion since 2010, market watchers are increasingly concerned that investor flows into and out of such passive vehicles can distort the pricing of the underlying securities.

ETFs generally are not viewed as affecting the equities or bonds to which they are indexed. But that view was challenged in early February, when all three major U.S. indices went into correction territory.

At the time, investors fled the markets after a better-than-expected jobs report raised the prospect that the Federal Reserve might become more aggressive on interest rate increases. Subsequent studies of the market dynamics at work back then suggested that the large outflows from ETFs could affect less-liquid securities.

Tracking the effects

As much as one-third of the February pullback could be traced to the $25 billion outflow from SPY, the main ETF tracking the S&P 500 Index, according to S&P Global Market Intelligence.

Though the outflow effect reversed in three to five business days, the S&P analysts noted, market participants said less-liquid assets could be vulnerable to the kind of added volatility wrought by fluctuations at the passive funds.

"Capital flows in and out of particular sectors of the market can artificially boost or decrease the value of specific asset classes," because of a lack of underlying liquidity, said Tim Ng, chief investment officer of Clearbook Global Advisors. That category might include such asset classes as emerging market debt and securitized credit, Ng added.

High-yield bond ETFs could also cause trouble for underlying assets, especially as they grow in size, said James Smigiel, chief investment officer at SEI Investments' management unit, in an interview.

Because bonds, unlike equities, are not traded on exchanges, when there is demand for the underlying assets during times of stress, they may not be available, causing irregularities in the pricing mechanism, Smigiel noted.

"So far, they've handled the little spats well, but have they really, truly been tested?" Smigiel said.

Calm in the storms?

In the relatively benign market environment of the past few years, "a correction would have to extend for a decent amount of time" for ETF flows to have a substantial effect on underlying securities, one active investor said.

"So far, we've had small corrections, and by the time investors pay attention, it's over," this investor said.

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ETFs also provide their own measure of liquidity, market participants agree, as well as price discovery when markets are stressed.

During a major high-yield bond market selloff in 2015, investors turned to the primary market in fixed-income ETFs for liquidity when the secondary over-the-counter market was hard to access, according to a July report from asset manager BlackRock Inc.

BlackRock is among the top three providers of the investment instruments through its iShares product; the other two are State Street Corp.'s SPDR and Vanguard Group Incorporated (The).

Even during times of outsize ETF flows, the instruments account for "less than 5% of the volume of trading in stock markets," said Ananth Madhavan, global head of iShares research at BlackRock, in an interview.

"For every dollar traded by index funds, some $22 is traded by active funds in search of an alpha opportunity," Madhavan said.

But the problem with some ETFs is that price discovery may be delayed because the underlying asset does not trade often. An international bond ETF, for example, will be benchmarked to underlying bonds that might not even trade every week, Cullen Roche, founder of Orcam Financial Group, said in an interview.

"So what the ETF is trying to track is, in real time, something that cannot be tracked," Roche said. "And this becomes exaggerated when the markets are under duress — things become less liquid because investors tend to freeze up."

And the market maker in the ETF being forced to sell to bring it back into equilibrium could put short-term downward pressure on underlying securities, Roche noted.

"In the short term, that kind of ETF could exacerbate market inefficiency," Roche added.