Exchange traded fund risk management and resiliency

Abstract

The rapid growth of exchange traded funds (ETFs) has raised questions about possible risks facing ETF investors. ETF is a sophisticated daily-dealing open-ended collective investment vehicle (CIV), combining properties of an investment fund and a capital markets instrument and requiring an advanced end-to-end risk management framework across the ETF market structure. This paper recommends ETF risk management best practices developed to meet fiduciary and regulatory responsibilities. The risks associated with ETFs and authorised participants (APs), which serve an important role in the ETF ecosystem, should be monitored and managed prudently and holistically throughout the product life cycle. Investment and liquidity risk arise in portfolio construction and parts of primary market creation and redemption process. Baskets are representative slices of the fund that can introduce unintended investment and liquidity risks if not managed appropriately. Liquidity risk also extends to the secondary market. Counterparty risk arises mostly through primary market activity and securities lending, but it can also be present in portfolios through usage of derivatives and other instruments with counterparty risk exposures. A robust and comprehensive ETF risk management framework should incorporate investment, liquidity, and counterparty risk monitoring with escalation, oversight and strong governance. These are the building blocks of a robust risk management framework, which should also protect ETF investors during periods of market stress. A number of events over the past several years have tested the resiliency of ETFs in volatile markets. The ability of ETF shares to trade on the secondary market without ever having to transact in the underlying security holdings provides a ‘release valve’ or ‘shock absorber’ for directional trading pressure.