Exchange-traded funds (ETFs) are the most successful passive financial products of recent years but there are some concerns about how these instruments perform and their implications for the rest of the market.

One of the recent charges brought against ETFs is that, due to their low cost, investors are piling into markets en masse and becoming a material factor in their performance.

Could they create a bubble?

As a case in point, a record breaking 2017 for ETFs has sparked fears they may be creating an unsustainable bubble in the US stock market. In the first two months of this year, $131bn was pumped into ETFs according to consultancy ETFGI. This follows a record breaking 2016 when ETFs gained $390bn in net new money.

Some think retail investors are falling prey to herd mentality instincts. In a scenario where investors lose confidence they could quickly move out of their ETF positions and send the market into freefall.

ETF providers aren’t convinced by this argument. Source ETF’s head of multi-asset research Paul Jackson says the idea that ETFs have made people pile in to markets is ‘nonsense’. He adds:  ‘People make the decision they are going to invest and then decide how they are going to do it.’

Lyxor’s Adam Laird, head of ETF strategy for Northern Europe, says that there’s no evidence of mass withdrawals by ETF investors that have led to events such as suspensions. He contrasts this to many open-ended property funds that prevented investors making redemptions after the Brexit result was announced.

‘From what I’ve seen, most investors use ETFs for a long term buy and hold strategy,’ says Laird.

Can you sell when you need to?

One of the proclaimed dangers of ETFs is that market turmoil can expose them as less liquid than their providers assume.

ETFs are easily traded on an exchange but extra liquidity is provided through a process known as creation and redemption. This occurs on an exchange once a day in the so-called primary market.

It allows authorised participants, such as institutional trading desks and other approved market makers, to exchange baskets of securities or cash for ETF shares (and back again) without having a meaningful impact on the underlying market.

This process can in theory provide unlimited liquidity to the fund, which in turn becomes a function of the trading volumes in its underlying index constituents, as opposed to the secondary market volumes in the ETF.

This ability to create and redeem shares at any time should keep an ETF’s price in line with its underlying net asset value (NAV) and ensures that its liquidity derives from the underlying market the fund is tracking.

This is important to understand; an ETF is only as liquid as its underlying assets. If one or more constituents of its benchmark index rarely trade, the ETF could have liquidity issues.

There are fairly simple ways of calculating how liquid an ETF is; one is the ‘bid-offer spread’. If an asset such as an ETF has a large bid-offer spread, it means that there is a big difference between what the owner of the asset is willing to sell it for and the price the purchaser is willing to pay.

However, most ETFs track highly liquid indices or baskets of bonds so it’s unlikely an ETF investor would be stuck in their position.

Lyxor’s Laird concedes that with any investment, if you need to trade during a crash or when markets are under stress you get a worse price ‘so you need to go into it with your eyes open’.  This is true of any investment during stressed conditions and not limited to ETFs.

What is the tax situation?

While US investors can take advantage of tax benefits when using ETFs the same is not true for UK-based investors. It is important to remember where your ETF is issued.

ETFs from the US and France face a particularly punishing tax regime because they enforce withholding tax. This taxes the dividends from ETFs at a high rate.

The tax status of UK ETFs is also crucial. Those given ‘reporting’ status are subject to capital gains tax and make up for around 75% of UK ETFs, according to Morningstar. Capital gains tax varies but is either 18% or 28% depending on your circumstances. The remaining 25% of UK ETFs do not enjoy ‘reporting’ status and gains generated through these products can be liable for income tax, which can be as high as 45%.

If you hold your ETF in an ISA or SIPP you should be shielded from tax except the withholding taxes applied for ETFs domiciled in the US or France.

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