Table of Content
1. Explanation of ETFs
2. Development of the ETF market
3. Risk’s for ETFs
When you read this seminar paper you get a basic understanding of all risks that can be involved in the ETF market. Furthermore, there is a focus on some regulatory rules for such funds. The paper is divided into 4 main parts. First, there is a basic explanation about ETFs and how they work. Second, we show the development of the last few years of the ETF market. The focus of our work lies on the third part which deals with the Risk of ETFs. Risks that are explained are: counterparty, liquidity and leverage risk. Fourth, there is summary of regulations of ETFs which are created by IOSCO and ESMA. Finally, there is a short conclusion which summarizes the whole seminar paper in a few words.
1. Explanation of ETFs
During the last few years, exchange traded funds (ETFs) have become a more important role in financial markets. The number of people who are investing in ETFs is still increasing. Therefore, it is important to get a basic understanding what ETFs are doing and which advantages and disadvantages they have.
The basic idea of ETFs is that they track an index of stocks, bonds, commodities or other assets. But in comparison to Mutual Funds most of the ETFs try to replicate an index by 100 percent. However, it is possible to invest 80-95 percent in the index and the remaining 5-20 percent in Derivatives to maintain the chance to outperform the index. These financial products can be traded at stock exchanges like common stocks of companies. One of the biggest advantages, comparing an ETF with a Mutual fund, is the possibility of intraday trading activities. Offers of mutual funds are accepted during the whole day, but can only be exercised at one point in time at the end of the day. In this point in time every market participant gets information about the actual course of the fund. In contrast to that, ETFs can be traded at every time when the stock exchange is open. Additionally, market participants are able to get information about the actual price of the ETF (Etterer, 2004).
An important thing which has to be mentioned is the indicative net asset value (iNAV) of an ETF. It is calculated by multiplying all assets in an ETF with its single prices on the stock market. The sum of all multiplications gets divided by the total amount of shares to get the value of an ETF. An actual value of the ETF is available at every time during a trading day. Mutual Funds adjust their NAV only once a day. However, the market price is not every time exactly the same than its iNAV. Therefore, it is possible to make arbitrage on the market price of ETFs. As a result, the market price will be close to its iNAV and adjusts to it very quickly (Hull, 2010).
In comparison to other investment strategies, ETFs have many advantages due to the fact that they track an index with very low costs and because of some strategies that they are allowed to use. Generally, they have the advantage of low costs, high transparency for investors, possibility of continuous trading on markets, high rate of flexibility, diversification of risk, high liquidity and many more (Etterer, 2004).
ETFs can be offered with very low costs for investors due to 2 main reasons. First, normally investors have to pay a subscription fee when they buy a fund. This fee can vary between 1% and 6%. Investors who want to invest their money into ETFs do not have to pay this fee. Secondly, the costs of an ETF can be kept very low due to the passive management. Most ETFs track a stock index and therefore do not need any kind of active management. The only thing that has to be changed is the proportion of the stocks in the ETF when the proportion of stocks in the index changes. Another big advantage of ETFs is that they provide a lot of information to investors. This high transparency includes information about actual courses, traded volume, Bid-Ask spread etc. and almost all information can be found in the internet. Especially the asset composition of ETFs is published every day. But there are other important issues which are not fully published that will be described in the third chapter. Furthermore, the pricing of ETFs is very simple and most of the time investors can have a look at the underlying index to get information about the performance of their ETF. In most of the cases the value of an ETF is about 1/10 or 1/100 of the value of the underlying index. Therefore, the percentage change of price of the index is more or less the same for the ETF (Etterer, 2004).
Due to the fact that an ETF consists of a lot of stocks, bonds etc. the diversification benefits are very high. Therefore, investors can reduce their portfolio risk by investing in an ETF. It is possible to react very fast to market changes, because of the continuous trading of ETFs. This provides a lot of flexibility for an investor. Furthermore, it is very easy to liquidate a position of an ETF due to the facts that are explained above.
However, these are only theoretical aspects and various shortcomings arise by looking at the practical implementation of many ETFs. The upcoming chapters will deal with the risks that have to be considered when an investor buys/sells such a fund. But before the discussion of risks in the ETF market starts, one will get a short introduction about the development of the whole ETF market within the last years.
2. Development of the ETF market
The basic idea of ETFs is to enable even small investors to have a well-diversified portfolio with low transaction costs. The purchase of several stocks is simply not possible for investors with strongly limited financial capabilities for various reasons. Thus ETFs are an efficient alternative for them to invest into an index which represents a diversified portfolio for a specific region or industry. However, as usual financial engineers invented evermore variations of ETFs like leveraged ETFs or reverse ETFs. Therewith ETFs are also used for speculation. The ETF industry became very large within a few years. In the third quarter of 2011 the global ETF industry already had $ 1.2 trillion in assets under management, where 85% of it has been plain-vanilla ETFs. These plain- vanilla ETFs are the pure and original ETFs passively tracking an equity index. However volume of the global ETF industry was already 2% of the global equity market capitalization in 2010. The ETF market is growing at high speed with on average 40% each year over the last decade. This is an incredible rate in comparison to the 5% each year for equity markets. Figure 1 shows the current trends in the ETF market by asset and ETF type. In 2005 equity ETFs have been almost exclusively. The share of fixed income and commodity ETFs increased heavily up to now. Another development is that synthetic ETFs gain more and more in volume especially in Europe and are currently nearly as important as physical ones. In contrast synthetic ETFs are much more restricted in the United States and thus they have a much lower share compared to physical ones (FSB, 2011).
Current trends in the ETF market
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Figure 1: Current trends in the ETF market
Source: FSB (2011)
In 2011 several international associations like the International Monetary Funds, the Financial Stability Board or the Bank of International Settlements published reports in which they stated their concern about the risks of synthetic assets. This will be explained in more detail later on. This was the starting point of a debate about the risks of physical and synthetic ETFs. Figure 2 illustrates that this debate was at the expense of synthetic ETFs which had large outflows in 2011 and thus losses in market share especially in Europe.
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- ETF Risk Exchange Traded Fund Regulation liquidity risk counterparty risk physical ETF Synthetic ETF managed ETF