FLASHBACK FRIDAY: Unraveling the ETF Bubble


Bubble? What bubble?

Just three years it appeared that exchange-traded funds (ETFs) prices were climbing through the stratosphere as lack of alpha in plain vanilla equities coupled with scarcity ETF product made the sector hot. To many, a bubble was a forgone conclusion and some in the industry were defensively positioning themselves from impending doom.

Back in 2015, guest contributor Tim Quast likened the ETF market to the mortgage-backed securities market circa 2004-5 where a finite amount of home loans were parsed, sliced and diced into more and more complex derivative instrument. And as Quast noted in his original piece, everyone remembers the ensuing financial meltdown that occurred. Quast made the same assertion about ETFs – “too many ETFs are dependent on the same stocks. When underlying share-prices experience prolonged flattening, derivatives predicated on them may be rendered worthless.”

So, what happened?

First, no bubble occurred. Yet.


Matthew Bartolini, SSGA

And as can be evidenced to even the casual observer, ETF issuers such as BlackRock, Vanguard, Invesco and other continued to issue ETFs backed by myriad new underlying company stocks – such as “green” companies, new tech firms and others. And investors flocked to the new supply. According to data from ETFGI, an ETF market consultancy, ETF inflows hit a high of $653.6 billion in 2017. Issuance last year dropped a bit to $516.1bn into exchange traded funds and products last year down about 21%. Still, ETFGI data show that 2018 inflow still represents the second-best year on record for the ETF industry.

Matthew Bartolini, Head of SPDR Americas Research at State Street Global Advisors recently spoke with Traders Magazine and said that despite disappointing returns for equity investors, ETFs still managed to attracted over $300 billion of inflows for the second consecutive year in 2018, according to his own data.

“ETFs second consecutive year with over $300 billion in flows was a first for the industry. Nonetheless, three out of the five major asset class focuses we track had a decrease in assets: Equities, Commodity and Specialty,” Bartolini said. “Considering that equity focused ETFs made up 80% of all ETF assets to start the year, if their assets decline, so do the industry’s.”

He continued to note that while fixed income ETFs broke their consecutive monthly inflow streak (38 in a row) during the year and didn’t surpass $100 billion in total flows, 2018 was still a good year. As a result of the risk-off market sentiment, bond ETFs amassed a staggering $16 billion in the month of December – the second highest monthly flow total of all time. With November registering the sixth highest flow total ever, bond ETFs closed out 2018 with the largest back-to-back month hauls ever. As investors continue turning to ETFs for asset allocation, Bartolini expects fixed income assets to continue this ascent, irrespective of market sentiment.

“Overall, stripping out market impact, the industry continued growing in 2018 and taking share from mutual funds that witnessed both negative market returns and outflows,” Bartolini said.

Deborah Fuhr, the co-founder of ETFGI, said recently in the Financial Times that the ETF industry’s remarkable growth was continuing to attract new entrants and significant product innovation. “We saw 49 managers enter the ETF industry for the first time in 2018 along with 877 products launched last year by 194 providers,” Fuhr was quoted as saying.

Also in the FT, Stephen Cohen, EMEA head of iShares at BlackRock, said investors increasingly viewed ETFs as the most efficient way to invest. BlackRock has forecast that global ETF assets could reach $12 trillion by the end of 2023, compared with the $4.8 trillion n currently under management. “More and better uses of ETFs will be fuelled by demand from investors looking for ways to access new exposures, achieve portfolio outcomes and make progress toward their long-term goals,” said Cohen.

What Can We Say Now About ETFs?

When I originally read this article in 2015, I thought to myself, here we go again. Yet another commentator on ETF market structure opining on how unchecked growth in ETFs represents systemic risk and a bubble waiting to burst. As myself a former ETF market maker and authorized participant and someone who has dug into the details of ETF creation/redemption and the market’s plumbing that makes ETFs work, I disagreed with many of the inferences made in the 2015 article,” began Spencer Mindlin, capital markets analyst at Aite Group.

First, he explained that ETFs are not like mortgage-backed securities. ETFs are transparent, and regardless of the replication model, an ETF’s exposure is ultimately backstopped by an instrument that provides that exposure.

Spencer Mindlin,
Aite Group

“For sure, an ETF’s use of use of derivatives can introduce additional risks, such as counterparty risk. But it’s incumbent on the investor to know what they’re buying and the risks associated,” he explained. “This can be helped by continual investor education, investor suitability screens, and industry coordination and adoption of a standard categorization and labeling approach to ETPs.”

Looking back to 2009 after the Financial Crisis and Crash, he recalled there were a series of reports that challenged the soundness of ETFs and ETF market structure. Many will remember the business media outlets and members of Congress went almost as wild about the substance of these reports as they later did about the purported evils of maker/taker exchange models and high frequency trading. There was the infamous September 2010 Bogan Associates report, “Can an ETF Collapse?” that Mndlin remembers claimed not only were ETFs responsible for the May 6, 2010 flash crash, but ETF shorting and excessive ETF redemptions can cause a fund to keel over and die. Like an elephant charging, the ETF industry defended itself and went on the offensive to try and discredit the report, which it did, as it should have. But the Bogan report raised eyebrows.

“Then there were two more reports in 2010 and 2011, and congressional testimony, by then CIO Harold Bradley (and Robert Litan) of the Kauffman Foundation (and CIO of American Century before that) who suggested that ETF failure-to-delivers serve as “canaries in the coalmine” of market structure and pose substantial systemic risk to the financial system given a crisis of liquidity. Kauffman wasn’t the only entity bringing up the problem of ETF settlement failures,” Mindlin continued. “Georgetown University Professor James Angel has penned more comment letters to the SEC than I can count discussing the topic of ETF settlement failures (and I looked forward to each and every one). And globally, several financial regulators issued reports highlighting how ETFs and ETF settlement failures were included in their list of potential sources of systemic risk in need of attention.”

For those interested, he pointed out that these ETF failures-to-delivers generally stem from (what I would explain as) a confluence of loopholes in SEC Regulation SHO and the ETF market maker’s cost of capital and preference to avoid the unnecessary or premature ETF creations.

Is there still a real chance of a bubble forming?

No, Mindin said strongly.

“But if there was, I don’t think we’re anywhere near that threshold. And the question is myopic,” he said. “US ETFs have approximately $4 trillion in AUM. Mutual funds have approximately $18 trillion of AUM. Mutual funds hold many of the same types of positions as ETFs, but we do not challenge the growth of mutual funds and accuse them of creating a bubble.”

He does however think it’s a fair question though to ask whether intraday trading volume of ETFs have the potential to cause outsized effects on the underlying markets and can cause the prices of the underlying assets to drift, sometimes far, from their fundamental value. As opposed to index-based mutual funds that generally trade their funds during the last hour or so of the trading day, significant intraday volume of ETFs have the potential to have an outsized effect on the market.

“Is this a bubble? Not really,” he argued.” But should volume or volatility rise to a point where the ETF tail is wagging the market dog, it’s a problem for end investors and the corporates with no tolerance to see their market cap whipped around.”

Are prices being held in check? If so, by what?

So, are prices are being held in check? Yes, Mindlin said, as the ETF arb keeps the NAV in-line with the underlying components. But market participants should consider whether the market is efficiently keeping the underlying issues trading at fair market value or is correlation creating dislocations to the company’s fair market value, he added.

Moving forward, he said many should consider the following:

  • The industry’s march towards best execution along with the unbundling of commissions has thrown into even more question the role of fundamental equity research and price discovery. In the old model, with all its faults, larger institutional accounts typically subsidized the costs of research for smaller investors. But post-MiFID II, only those investors that can afford to pay the full sticker price of a top analyst’s time will get the benefits of their services.
  • Assuming markets are not efficient, increased indexing implies increased asset correlation.
  • More intraday index-based trading has the potential to create more dislocations.
  • No doubt, passive is in. But without a vibrant community of traditional active managers participating in the markets on behalf of end investors, it’s only the intermediary firms with access to the fastest technology, the best and the brightest talent, and a seat in the middle and able to detect intraday or multi-day price dislocations that can profit from the arbitrage.


The following article originally appeared in the January 2016 edition of Traders Magazine

FLASHBACK FRIDAY: Unraveling the Ramifications of the ETF Bubble

By Tim Quast

The risk of an ETF bubble is very real as guest commentator Tim Quast suggests in this op-ed where he paints an engaging and detailed picture of what might lie ahead if this asset class continues its meteoric growth.

Exchange-traded funds are this era’s mortgage-backed securities, fostering value-distension in global bonds and equities.

In Michael Lewis’s book “The Big Short,” a small group of people come to believe mortgages are a bubble because they’ve been extended into derivatives that duplicate demand without expanding the assets underpinning them.

Like mortgage-backed securities, the stock market is built on a finite supply of underlying assets (shares). Because companies keep buying each other and their own shares, supply is static. Big brokers who once carried many stocks to sell don’t in a Dodd-Frank world, and the new intermediaries, fast traders, often have but 100 shares at a time. What are big stock-buyers to do?

Enter exchange-traded funds. Through ETFs, institutions transfer the risk of finding shares to an arcane behind-the-scenes group of custodian brokers called in ETF lingo “authorized participants.” You can’t find a list of these APs but experts say they’re big banks getting special permission from ETF sponsors to act for them. They’re managers of stock warehouses in a sense.

Here’s how it works.

Blackrock creates an ETF tracking an index that must be comprised of percentages of each stock. Blackrock turns to the AP warehouse which packages vast amounts into “creation units.” Only the AP can sell ETF shares back to Blackrock. For investors, ETFs must be bought or sold on the “secondary market” like stocks. But where more demand drives stock prices higher, not so with ETFs. If investors want the ETF, Blackrock has its AP manufacture more units – theoretically creating infinite supply.

ETFs in effect cut out the middle man, the stock market. ETFs can substitute cash or securities like options and futures for stocks, or sample the indexes they track. There are only two ETF types, physical and synthetic, with the former either owning shares or sampling them, and the latter relying on derivatives to represent the value of stocks. ETFs track indexes four ways:

1) Full replication. The ETF buys all stocks in the underlying index, matching comparative weighting. It may substitute cash for some or all of the stocks.

2) Sampling. When the tracking index is large or if the stocks aren’t available in sufficient quantity, an ETF may construct a representative sample of the index and own only those stocks.

3) Optimization. This quantitative approach uses mathematical models to construct correlation in a set of securities that trade like the index whether they reflect industry characteristics or not.

4) Swap-replication. ETFs pay counterparties for rights to the economic value of underlying indices. No assets actually trade hands.

It’s worth noting that the great majority of bond ETFs use sampling because the number of fixed-income issues is staggering and most are illiquid so full replication is a physical impossibility.

We’re led to believe APs can always get shares of stock. Yet in 13F regulatory filings required by the SEC, holdings for the biggest investors like Blackrock and Vanguard barely budge. The 2015 Investment Company Institute Fact Book says turnover since 1980 had averaged 61 percent annually, but in the ETF era (2003 to the present) it’s just 42 percent.

Facts cannot contradict each other and remain true.  If institutions aren’t selling positions, how can ETFs proliferate by holding the same stocks?

I have a theory. Big passive index and mutual fund managers that roll up 13Fs to the parent-level are moving the same shares into and out of indexes and ETFs through APs during the creation-redemption process.

Or ETFs are substituting and sampling prolifically. Whatever the truth, ETFs are thriving because they make it easy for investors to get big exposure to assets without actually buying them. Collateralized debt-obligations did the same for mortgages, repackaging them into broadly accessible derivatives.

Suppose the stock market stalls for an extended period.  Investors get nervous and collectively sell stocks, indexes and ETFs. In our scenario, one or more of the core elements of ETF architecture will hold nothing.  It could be an AP tangled in swaths of valueless derivatives, like banks in the CDO market.  Losses in trading operations would be telltale.

It could be the sponsors themselves. Backing up to the Aug.-Sept. market swale, index and ETF volume was then up 120 basis points over the long-run average. Now, 1.2 percent might seem small but it’s more than $2 billion daily, sustained over 20 trading days. And the S&P 500 dropped 5 percent.  At that ratio, if 10 percent of investors wanted out, the market could decline 50 percent.

The mortgage crisis taught us a lesson about derivatives. Mortgages were replicated through them as demand for returns on real estate outstripped supply. When mortgages stopped increasing and houses fell in value, mortgage derivatives imploded.

The risk I propose here may never manifest. But in the May 6, 2010 Flash Crash, 70% of halted securities were ETFs. On Aug 24, 2015 when markets plunged, there were 1,000 ETF volatility halts.

Too many ETFs are dependent on the same stocks. When underlying share-prices experience prolonged flattening, derivatives predicated on them may be rendered worthless.

Tim Quast is founder and president of market structure analytics firm Modern Networks IR in Denver.

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