ETFs played a significant part in the global stockmarket falls around the China fallout and their increasing popularity could cause greater volatility in the future, Woodford Investment Management’s Grant Wentzel says.
There was pandemonium in global equity markets on 24 August when the ramifications of China’s troubled economy came to the fore.
Global equities went into freefall, with China equities closing down 8.5 per cent and the FTSE plummeting 6.8 per cent at its lowest point, prompting the last week of August to be “one of the most volatile we have seen in global equity markets for several years”, says Wentzel, head of trading at Woodford Investment Management.
There were “fundamental triggers”, such as the Chinese stockmarket nosediving and halving from its peak in June, decimating more than the total capitalisation of the UK stockmarket and dragging down emerging market currencies, emerging market equities and the high-yield debt market, he says.
However as well as “heavy selling pressure in equity futures ahead of the US open” the trading activity in ETFs could be “another significant reason for the market instability and volatility”, he says.
While ETFs, which are designed to track a basket of assets, have proved popular, with assets in the ETF industry now at $2.97trn (£1.95trn), many ETFs have grown significantly larger than the underlying assets they follow, Wentzel says.
“They are traded in huge volumes as a separate asset class but some of them no longer resemble their underlying assets,” Wentzel says. “This isn’t an issue when markets are calm but, in volatile conditions and amid high volume, outsized ETFs appear to amplify the underlying market moves. The advent of double and triple-levered ETFs exacerbates this effect even further.”
On 24 August, ETFs in the US saw almost three times the amount of trading activity as usual, amounting to $270bn in transactions, according to Goldman Sachs, with “numerous examples of erratic trading”, Wentzel says.
“For instance in the first few minutes of trading, the $5.8bn Vanguard Health Care ETF fell 32 per cent but the value of the underlying holdings fell only 6 per cent. The trading of the PowerShares S&P 500 Low Volatility Portfolio ETF fell over 45 per cent [in the first 15 minutes of trading] but within an hour it was down only 2.6 per cent.”
The volatility was likely to have been further compounded by automatic stop-loss orders that are triggered when a stock or ETF passes a level pre-set by private investors, Wentzel adds.
“Ironically, ETFs were, in part, originally designed to satisfy the demand for an intraday trading option from private investors that wanted to trade more frequently than a daily-pricing fund could allow. Clearly they have an important role to play for some investors but it appears their success has brought some unwanted side effects.
“For now, ETFs are a much more powerful force in the US market than they are in the UK. However, their emergence may suggest that we could face greater volatility going forward.”