ETFs Are A Solution To Financial Stability, Not A Curse

At the start of April Andrew Haldane, the Bank of England’s financial stability director, gave a speech to London Business School about the risks the asset management industry pose to financial stability. The speech highlighted ETFs and passive investments as potential contributors to future financial instability.

Haldane worries that the rise in passive investing makes it more likely investors will to flock to the best performing assets and returns from different investments will become more correlated. Whilst these concerns have justification, I fear Haldane sees only half the argument.

One reason for the rise in popularity of ETFs and, to a lesser extent, tracker funds is that these products give different types of investor access to indices, assets and markets they could previously not buy. A broader base of asset owners is a solution to, not the cause of, financial market instability.

There are currently over 1,100 exchange traded products listed on the London Stock Exchange, with roughly three times that number worldwide. These are transparent investments, listed on public exchanges, covering a multitude of assets. Many of these were previously only accessible to specialist institutions. For investors striving for high returns whilst controlling risk through diversification the benefits are clear, but this also helps the markets. Investors with different objectives, time frames and risk tolerances are less likely to move together in the herd-like fashion Haldane fears.

There is a concern amongst some that ETFs are a tool for speculators. Whilst it is true they can be used in this way, it would be unfair to lay all the blame at ETFs' door. Short-term investing has been around much longer than the 20 years since the first ETF was launched; investors who wish to trade tactically have always found an instrument to do so. ETFs at least give us transparency – they are listed on public exchanges and many issuers adhere to high levels of disclosure.

It would be a mistake, however, to assume that ETFs are only used by traders. The largest products are not niche, esoteric or leveraged. They track broad, mainstream assets and can be used for the core of a portfolio. Furthermore the most popular ETFs track market capitalisation-weighted indices, which invest the greatest proportion in the largest, most frequently traded securities. It is through this structure that ETFs allocate capital to the stocks most able to bear the flows.

There is an irony to the fear that passive investing will increase correlation amongst asset returns. Investors buy tracker funds to hold every stock in an index, to increase diversification in their own portfolio – not to reduce it for everyone else.

Correlated returns are a danger but I cannot attribute this solely to the rise in index tracking products. In times of market stress, prices fall in unison because the market cannot distinguish the good from the bad. As technology improves we can process more data and react more quickly. This efficiency should make the markets more stable, but we cannot forget it will also make passive investing appealing to many investors.

Do not forget ETFs themselves play an important role in market efficiency. Investors in Frankfurt use them to trade baskets of Australian stocks when the market is closed. ETFs tracking illiquid bonds are priced throughout the day, even when their underlying holdings are not. This is all part of the markets’ price discovery process.

To conclude, Haldane's speech raises a number of valid concerns about the structure of asset management but I maintain ETFs are rather a solution to financial market instability than a concern. As passive investing becomes more prominent in asset management I expect it will attract more scrutiny but I look forward to engaging with the Bank of England and other regulators about how these problems will be best addressed.

Adam Laird is passive investment manager at Hargreaves Lansdown