Charlotte Moore looks at how investors have used ETFs to handle - and profit from - the volatility in the last two years
The last two years have been a white-knuckle ride for every type of investor as the biggest crisis since World War II ripped through the financial system. Not only did financial markets plunge but volatility reached record highs.
For those who work in the financial markets, the biggest ongoing headache is that investors often become like bunny rabbits stunned by a bright light: simply too afraid to do anything at all. Then trading volumes tumble and commission income dries up.
“The volatility and uncertainty bedevilling the financial markets recently has helped to underline the utility of ETFs for investors.” Tim Mitchell, Invesco Perpetual
In the ETF universe, however, investor activity has continued. The pace of growth has slowed over the last two years but it has not declined. According to Barclays Global Investors (BGI), assets under management at the end of June were $789bn – almost the same level as at the end of 2007. In fact, ETFs have stolen market share from other financial products.
Tim Mitchell, head of listed fund sales at Invesco Perpetual, said: “The credit crunch meant that concerns over swap counterparty risk mushroomed and investors turned to ETFs instead as they were reassured by the safety conferred by their Ucits III structure.” The broad range of asset classes covered by ETFs and their low dealing costs have been added incentives.
When the global financial crisis broke in the middle of 2007, it had little discernable impact on the growth of ETFs. According to BGI, assets under management by the end of that year reached a record high, posting an annual growth of 41% to $796.7bn.
Initially investors were confident that crisis would be contained. At first they thought it was a localised sub-prime problem. Once it became clear that the problem would spread through the economy as whole, conventional wisdom was that it would be confined to the West as the Chinese and Indian economies were thought to be strong enough to exist in their own right – their economies had decoupled from the West.
Manooj Mistry, head of equity ETF structuring at Deutsche Bank’s ETF arm, db x-trackers, said: “To reflect that optimism about the emerging markets, in the first few months of the crisis there was a range of new emerging market funds launched. Uptake of these products was good.”
But faith in the decoupling theory was gradually undermined at the start of 2008 – the decoupling theory seemed to be no more than an over optimistic pipe dream. “Assets came flooding back into the developed markets as that was seen as a safe haven,” said Mistry.
It was the collapse of Lehman Brothers in September 2008, however, that caused the biggest shock to the system. Equity markets around the world went into freefall and the emerging markets and the US were both hit hard. By the end of the year, the FTSE 100 had fallen by 12% but the Hang Seng fell by 22% and the S&P 500 by 26%.
In the chaos that ensued, investors scrambled for a safe haven. “Fixed income ETFs were a big winner,” said Mistry. According to BGI, the assets invested in fixed income ETFs have grown from $6.3bn in 2007 to $16.4bn by the end of June.
Volatility was rife, with markets moving by as much as 5% to 9% in one day. “We’ve noticed that when market values fall, there is a corresponding surge in ETF trading. Investors see it as a quick and easy way of getting access to markets that will soon rise,” said Mistry.
Investors could also make money out of ETFs when the market fell, as investors can also short these funds. Paolo Giulianini, head of ETF trading and advisory at Unicredit Group, said: “We’ve seen a rise in demand from investors who want us to lend out ETFs so that they can go short on an index.”
One of the most lucrative shorting plays over the past few years was against the oil price. Canny investors knew that a fall off in economic growth would be accompanied by a falling oil price.
After the collapse of Lehmans, those investors who had to hold equities turned to classic defensive stocks that provide steady cash flows even in times of trouble. There was a corresponding rise in ETFs that tracked sectors like pharmaceuticals or utility stocks.
“We’ve seen investors using ETFs as a way of rotating between sectors, as well as a way of getting in and out of particular equity market sectors,” said Mistry.
Signs of life
After a truly dismal first quarter, the outlook turned less gloomy when financial markets started to rally at the start of March. That rally has been sustained, so far, with equity markets around the world bouncing back.
But the most dramatic recovery has been in the emerging markets. While the FTSE 100 and S&P 500 have rebounded by 27% and 40% respectively, the Hang Seng has risen by 61% over the same period.
As the dust has settled on the financial crisis, it is become increasingly clear that while China, India and Brazil have suffered collateral damage, they have not been mortally wounded.
Most investors believe that global economic growth will remain subdued for several years but all the growth will be coming from the emerging markets. The decoupling theory no longer looks quite as fundamentally flawed as it did several months ago.
The recovery of the emerging markets has been volatile, with indices posting huge movements in the blink of an eye. Giulianini said: “India’s stock market gained 25% in one day after the announcement of the elections.”
Such enormous moves make a substantial difference to an investor’s profit and loss account if they miss out. Giulianini said that ETFs have enabled investors to be much more nimble and nip in and out of markets to take advantage of these moves.
“ETFs trade for nine hours in Europe on the same day so you can ensure you crystallise your gains. Rather than staying up all night to trade on the Asian markets, ETFs can trade after their morning close, which ensures you don’t miss out on any major moves while you’re asleep,” explained Giulianini.
As the emerging markets returned to investor favour, funds have also started to flow into ETFs that track commodity prices. “We’ve seen the assets under management in our commodity funds grow from €180m to around €600m over the past six months,” said Mistry.
It is not only commodity ETFs that are seeing the number of assets under management grow. Before the global financial crisis, investors were looking for a broad range of alternative assets to spread the risk. However, this strategy did not seem to help much in the face of the financial storm as correlation shot up and every asset class moved downwards together.
But investors are once again looking for different assets that are not so heavily correlated to movements in the equity and bond markets. “We’ve seen investors putting increasing sums of money into currency ETFs, as these are now being treated as an asset class in their own right,” said Mistry.
Back to basics
Even if investors are once again putting money back into financial markets and embracing the concept of diversified assets, the mood has changed significantly since the global financial crisis hit.
Mitchell said: “When investors started to pick up the pieces after the financial crisis, they went back to basics. There is an increasing sense among investors that it’s all about getting the asset allocation right and using passive rather than active strategies to achieve this.”
Mistry agreed: “We are seeing investors focus on allocating assets correctly rather than looking for active managers.”
Providers of ETFs will carry on bringing out new ETFs in response to investor demand. “There is a growing concern that inflation will rise steadily over the next 12 months as government spending has increased to boost economic activity. So we recently launched an ETF linked to an inflation swap index,” Mistry said.
However, Mitchell believes that more complicated products may not be the answer right now. “I think you’ll see a continued flow of assets into ETFs but I don’t think that there will be that many ‘whiz-bang’ new products launched. Investors want simple, easy to use products.”
With so much uncertainty remaining over the global economic outlook, investors will have to remain on their toes and react nimbly to any market movement – but ETFs may be the tool that makes that easier.
“The volatility and uncertainty bedevilling the financial markets recently has helped to underline the utility of ETFs for investors. Things look set to remain uncertain for a good while longer and I’m confident that investors will carry on using ETFs to make the most of the opportunities thrown up,” said Mitchell.
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