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Why ETFs may not be as risky as one report suggests

The European Systemic Risk Board (ESRB) concluded in a recent report that exchange-traded funds (ETFs) could pose a systemic risk during times of financial stress. But Benchmark Investments CEO Kevin Kelly doesn’t buy that argument.

“What I find funny is that ETFs are used to be the boogey man for all that woes the markets,” Kelly told Yahoo Finance’s On the Move. “But if you look at the overall ETF market it only represents 6% of asset classes.”

The ESRB report suggests that ETFs could lead to systemic risk in the global financial system through four main channels, 1) higher volatility and co-movement of security prices during times of market stress if the ETFs constituent securities are illiquid. 2) decoupling of ETF prices from those of its constituent securities with destabilizing effects on institutions that rely on ETFs for liquidity management. 3) contagion among investors with large correlated exposures in the event of sharp ETF price drops and 4) potential operational risk for ETF providers when markets tighten.

But Kelly said the report makes one big mistake. “The European regulators and this study was really focused on the nature of the assets in the actual ETFs over [in Europe]. And the problem was a lot of their ETFs use what’s known as synthetic exposure.”

While 70% of European ETFs track equity indices, the ESRB report cites a growing trend of more complicated ETF products that use derivatives within an ETF and lack full replication of the indexes they’re tracking.

U.S. ETFs “are mostly equity-based and trade on centralized exchanges, European ETFs more often track fixed-income securities, trade on OTC markets and rely on cash redemptions in the primary market,” according to the ESRB report. But Kelly, whose firm Benchmark Investments creates indexes that track different asset classes like the SCTR which tracks publicly traded real estate securities, said “We know that ETFs here in the United States typically hold deep and liquid assets, hence why they are the preferred vehicle.”

ETFs are liquid

Despite the popularity of ETFs, the ESRB report says they account for a small portion of total market capitalization. In the U.S., ETFs account for 30% of the daily trading volume in U.S. stock markets. But different types of ETFs are growing as new ETFs are created to track underlying assets from equities, commodities, currencies and bonds.

iShares fixed income strategist at BlackRock, Jon Rather, recently discussed the growth of ETF bond funds which are expected to hit $2 trillion in value by 2024 but even then it will only comprise 2% of the global fixed income market.

“If you look at U.S. equities, equity ETFs are about 10% of the U.S. equity market. And I think investors are just starting to recognize a lot of the same benefits of equity ETFs, namely efficiency, transparency, and simplicity also hold true for bond ETFs,” Rather said.

“I think that’s the most important key takeaway that investors need to know is that they’re (ETFs) a de minimis part of the overall market when you’re talking about the actual assets that they own and control,” Kelly said. “The best part of an ETF is that it gives you the actual liquidity.”

Adam Shapiro is co-anchor of Yahoo Finance On the Move.

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