The good, the bad and the market structure

The pros and cons of using Exchange Traded Funds.


So much has been written about Exchange Traded Funds (ETFs) and their increased use by individual and professional investors since they were launched by State Street Global Advisers (SSGA) in 1993. ETFs are a very useful instrument for investors, especially multi-asset-class investment managers. However, caution is warranted to avoid liquidity pitfalls and feedback loops. In this article we will explain the pros and cons of using ETFs in investment portfolios and using an example, why we believe it is critical to have a firm understanding of a market’s structure.

ETFs are investible listed securities that track the performance of a defined basket of investment securities

Unlike unit trusts, which cannot be accessed through the stock exchange, ETFs trade like any other stock-on-stock exchange. Such baskets of securities are often comprised of shares, bonds and/or commodities. In the case of commodities, ETFs track performance and are structured as non-interest-bearing debentures and are backed by the corresponding physical commodity. An example of an ETF trading commodity on the main board of the JSE is the NewPlat ETF, which is backed by physical platinum. An example of an ETF that tracks a basket of shares is the Satrix Resi ETF, which tracks an index basket of the largest 10 resources companies listed on the JSE ranked by the investible market cap, with the weight of each share in the index capped at 30%.

A company that creates ETFs is called an ETF provider

As the first ETF provider, SSGA launched their first ETF to track the S&P 500 Index. The ETF market has since matured tremendously and in South Africa we already have a long list of ETF providers. Liquidity for ETFs is facilitated by Authorised Participants (AP), which are usually banks. They have the right to redeem or create shares in an ETF, that is, to trade in the primary market.

ETFs are a very useful instrument for investors, especially multi asset class investment managers.

Source: Bloomberg
The benefits of ETFs in portfolio management

ETFs are beneficial to investment managers as they allow them to change their asset allocations swiftly and efficiently without having to buy or sell many single investment securities. This is made easy by the fact that there are ETFs that cover asset classes, sectors, geographic regions, industry groups, risk premia strategies and themes. Let’s say a portfolio manager wants to tactically increase his exposure to long-dated US Treasury bonds. In a single trade, the portfolio manager can buy a high-quality ETF (called a TLT) that tracks a market-weighted index of debt issued by the US Treasury with remaining maturities of 20 years or more.

Regarding liquidity or price discovery, it is worth noting that ETFs enjoy good liquidity. Liquidity in the secondary market is largely determined by the pool of market makers that trade the ETF. On transparency, ETFs that most investors trade in disclose their holdings daily.

On transaction costs and fees, management fees on ETFs are typically lower than other collective investment vehicle structures.

More on price discovery

Since ETFs trade in the secondary markets as single securities, the market trading price may differ from the Net Asset Value of the underlying securities. An AP has a financial incentive to step in to rectify any premiums or discounts in the ETF price relative to the value of the underlying securities. If the price of the ETF traded lower than the value of the underlying securities (ie at a discount), an AP can buy shares of the ETF and redeem them with the ETF issuer to receive the higher valued-securities, thereby capturing a profit. The converse is also true.

In an arbitrage-free world, an ETF would trade at the exact same price as the underlying securities. However, an arbitrage-free world assumes frictionless trading. In liquidity events, trading is no longer frictionless. APs and market makers often reduce their operations as volatility picks up and prime brokers also begin to withhold balance sheet access from their APs and market-maker clients. In these situations, the discounts or premiums can begin to grow. Notably, these liquidity constraints also impact the markets of the underlying securities.

Systemic risks that can arise due to the market’s structure

At Argon, we pay particular attention to the market structure. Since our investment philosophy views markets as Complex Adaptive Systems, we find it important to have a firm understanding of market fragilities and contributors to systemic risks. This is true for ETFs, where evidence suggests that ETFs contribute to systemic risks in several ways:

  • The prevalence of ETFs results in increased co-movement and higher volatility.
  • Large premiums/discounts in times of market stress can place a financial institution in stress if they rely on ETF liquidity.
  • Investors are driven to take large-correlated bets which may result in contagion in the event of large ETF price falls.
We believe it is crucial to focus on the interrelated nature and relationships in the financial system

The events in the US bond ETF markets in March 2020 are very illustrative. At the time, we had US Treasury ETF positions to hedge our portfolios against the imminent market fall. Once our models and indicators pointed to imminent market-wide deleveraging, we acted swiftly to take profits on these ETFs. Shortly thereafter, the discount on the ETF expanded to a record width (see the chart above). Furthermore, due to feedback loops, the underlying securities began to collapse in an otherwise counter-logical fashion. Investors were astonished that the countercyclical US Treasury bonds were collapsing during a risk-off event. However, at Argon, as an active, research-driven investment management company, we believe that value unfolds over the medium to long term. And we have learned over time, market structure implications always trump this kind of assumed logic.