Exchange-traded funds, commonly known as ETFs, are becoming increasingly important for investors. The Bundesbank’s latest Monthly Report takes an in-depth look at how they work and how they are structured, and analyses what risks they may entail for investors and for the financial system as a whole.

ETFs currently make up 14% of global assets under management, meaning this product class is playing a relatively low-level role for now. The Bundesbank judges that their significance is growing, however, and notes in the Monthly Report that “the ETF segment has grown enormously in recent years, making it an increasingly important fixture of the financial markets”. While 2017 saw traditional open-end investment funds increase their assets under management by approximately 5%, ETFs recorded growth of around 19% over the same period. 

An alternative to traditional investment funds

ETFs provide investors with the opportunity to invest in a broadly diversified portfolio of shares and other asset classes – as do conventional open-end investment funds. Unlike in the case of traditional investment funds, however, investors do not buy ETF shares directly from an investment company at a set price, but instead trade them at the market rate on the stock exchange. This entails far lower one-off costs – such as front-end loads – than are involved with conventional investment funds. 

The running costs – including, in particular, remuneration for fund management – are also cheaper with ETFs than they are for classical investment funds. This is mainly because most traditional investment funds primarily strive to exceed index performance through active investment decisions. In return for their efforts, fund managers expect regular commensurate remuneration. ETFs, meanwhile, are – for the most part – passive investment products: in general, their objective is to replicate index performance as closely as possible without the intervention of active investment decisions made by fund managers.

Particular risks of ETFs

As the Bundesbank explains, ETFs are exposed to ordinary market risks, meaning that they may occasionally experience significant volatility. In the Monthly Report, however, Bundesbank experts devote particular attention to analysing whether ETFs also carry specific additional risks when compared with other investment vehicles, especially individual securities and traditional investment funds. “Overall – and partly because the sector is still relatively small – the specific risks for the financial system associated with ETFs appear limited for now,” concludes the report. 

Flash crashes

The Bundesbank’s experts also examine the role of ETFs in a series of flash crashes, a term used to describe the unusually sharp and rapid slumps followed by swift price recovery that have been observed on stock markets in particular for some years now. The Bundesbank concludes that it is quite possible that ETFs may amplify particularly turbulent phases on the financial markets in the short term. In the course of various flash crashes, certain ETFs’ market prices were also seen to drift from their underlying index. The specific market structure may play a role in that phenomenon, according to the Bundesbank. The report argues that the ability to halt trading in the event of significant price changes therefore constitutes an important safeguard against the rapid spread of distortions on the financial markets.  

Other specific ETF-related risks stem from liquidity problems which may arise, explains the Bundesbank. Authorised participants are particularly key figures here. Together with ETF providers, these agents play an important role in ETF creation. They also bring ETF shares onto the market and keep trading running. The Bundesbank warns that, in periods of market turbulence, authorised participants may become unable to perform their linking function. In the unlikely event of a breakdown in AP activities, ETF providers may be obligated to buy back ETF shares at short notice, even if they cannot themselves immediately find a buyer for the underlying securities as prices dip. The experts explain that even “in a higher illiquidity scenario such as this, the trading price of ETF shares could fall below the value of the underlying portfolio”. In that case, the faster fund investors moved to sell their ETF shares, the higher the price they could expect to achieve. This behaviour further reinforces the negative price effect, “thereby exacerbating liquidity problems or even creating such problems in the first place”. 

Given the key position of authorised participants, one of the authors’ proposals is that an ETF provider should be linked to multiple authorised participants for each of its products, making it easier to offset the effect of one agent dropping out. The Bundesbank also argues in favour of creating a clearer, more transparent framework of rules for the obligation on ETF providers to buy back shares – a move which would offer extra protection for private investors in particular.