Exchange-traded funds (ETFs) have democratised the investment world, offering ordinary investors low-cost access to asset classes that were previously the preserve of institutional money managers. However, there are fears that ETFs may also be a source of peril – both to ordinary investors and, in a worst-case scenario, to the broader financial system.

ETFs are similar to ordinary funds in that they provide access to a basket of stocks. However, they trade like stocks and can be bought and sold throughout the trading day.

The most well-known ETFs track equity indices such as the S&P 500 or the FTSE 100, although the choice of asset classes is growing all the time. The latest figures from research group ETFGI show global ETF assets now exceed $3 trillion, with 5,757 exchange-traded products listed in 51 countries.

Leveraged ETFs

Some, such as leveraged ETFs, are controversial. Leveraged ETFs, which aim to deliver two or three times the daily return of a particular index, are popular with speculators seeking to juice returns.

In the past, concerns have been aired regarding the dangers of leveraged ETFs being used by long-term investors. Leveraged ETFs aim for a multiple of an index’s daily return, but prices can get out of whack over longer holding periods.

For example, US regulators have pointed previously to how one leveraged ETF fell by 53 per cent over a five-month period in 2008-2009, even though the underlying index actually gained 8 per cent.

Investors should be well aware of this by now, given that the dangers of long holding periods have been drilled home in recent years, both by regulators and by leveraged ETF providers.

Others have different fears. Larry Fink, chief executive of Blackrock, the world's largest asset manager, warned last year that leveraged ETFs contain "structural problems that can blow up the whole industry". Many fear leveraged ETFs exacerbate volatility in markets, pumping prices higher on positive days and amplifying moves to the downside in times of stress.

Such concerns led to the introduction of a moratorium on new leveraged ETF managers in 2010 – that has yet to be lifted.

However, defenders of leveraged ETFs argue that they are too little used to be a destabilising factor, given that they accounted for just 2.1 per cent of total US ETF assets in 2014.

A Federal Reserve study into the subject last November concluded fears regarding leveraged ETFs are "likely exaggerated". In March, that stance was reiterated by Securities and Exchange Commission commissioner Michael Pinowar, who described such fears as "baseless".

Physical v synthetic ETFs

Leveraged ETFs are not the only source of debate. Investors can choose from two kinds of index ETFs – physical or synthetic – and both have their fans and detractors.

A physical ETF is easily understood. Like an ordinary index fund, it holds the constituent stocks of the index being tracked. Synthetic ETFS, which are widely used in Europe, need not buy the shares in the underlying index. Rather, the ETF provider engages in a swap contract with a counterparty – generally, an investment bank – who promises to pay the index returns to the fund.

Why bother with synthetic ETFs? Well, they tend to have lower management fees and to track more accurately their benchmark index, especially in less liquid markets.

Additionally, they can provide investors with access to asset classes that might otherwise be denied to them. For example, instead of buying and storing physical commodities, investors can buy a synthetic commodity ETF.

The obvious problem is that investors are exposed to counterparty risk – the possibility that the bank backing the ETF goes bust. Such a prospect, however remote, will give many investors pause for thought, given the weakness exposed in the global financial system in recent years.

Synthetic ETF providers point out that the worst-case scenario is not as bleak as it might appear. European regulations demand counterparties post collateral – at least 90 per cent of the value of the ETF – to limit investor exposure. Additionally, most ETF providers choose to fully or overcollateralise their derivative exposure.

The complications surrounding synthetic ETFs, however, mean risk-averse investors instinctively prefer to stick with physical ETFs. But there are quirks also associated with physical ETFs.

Most physical ETF providers lend out stocks to third parties (for example, to short sellers). They receive fees for doing so and can make further gains by earning a return on the collateral held while the stock is on loan. But what if the borrower does not return the stock? What if the collateral falls in value?

Again, one could counter that trading desks are designed to manage such risks. Additionally, conventional managed funds also lend out stocks – the practice is not confined to ETF providers. Indeed, an International Monetary Fund report in April suggested that managed funds, like ETFs, could potentially pose risks to markets.

Liquidity

Some ETF concerns, perhaps, may be overblown, while others are common to the fund management industry in general. Still, some high-profile names have voiced concerns relating to another area of debate, namely the much-vaunted liquidity provided by the ETF industry.

Various ETFs, as noted earlier, allow access to illiquid asset classes such as leveraged loans, junk bonds and emerging market bonds.

There may be large trading in such ETFs, providing what Bank of England governor Mark Carney recently termed the "illusion of liquidity" in assets that have traditionally been difficult to trade.

This "illusion" also bothers influential investor Howard Marks, the billionaire co-founder of Oaktree Capital.

In a recent quarterly letter, Marks cautioned that no investment vehicle can truly be more liquid than its underlying assets. Furthermore, liquidity can vanish in a crisis situation, just when investors most need it.

Additionally, Marks is concerned that, in a nervy market where everyone is looking for the exit door, mass sales of ETFs may actually affect prices of the underlying assets.

If ETF investors rush to withdraw their assets en masse, it may trigger forced sales of the illiquid underlying bonds. As the bonds themselves remain illiquid and hard to trade, a wave of sell orders could prove overwhelming, exacerbating volatility and driving prices downwards.

“Will ETFs prove liquid in the next crisis?” asks Marks. “And what impact will mass sales of ETFs have on the prices of underlying assets?”

On the whole, few investors would deny that ETFs have been of huge benefit to both ordinary and institutional investors, providing them with low-cost and liquid access to innumerable asset classes. Liquidity can come and go, however. Something that can be easily sold today may not be easily sold tomorrow, and therein lies the danger of the “liquidity illusion”.

As legendary bond investor Bill Gross cautioned last week: "All investors cannot fit through a narrow exit at the same time."