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ETFs and its Risk Potential
IUBH School of Business and Management
Campus Bad Honnef · Bonn
Mülheimer Straße 38
53604 Bad Honnef
Germany
The Rise of Exchange-Traded Funds (ETF) and its Hidden Risk Potential for Financial
Markets
Florian Leister
Date: January 11, 2016
ETFs and its Risk Potential
i
TABLE OF CONTENTS
Table of Contents ........................................................................................................................ i!
1. Introduction ............................................................................................................................ 1!
1.1. Definition of ETFs ......................................................................................................... 1!
1.2. History and Development of ETFs ................................................................................ 2!
2. Risks for Investors ................................................................................................................. 4!
2.1. A False Sense of Security: Stop-loss Orders .................................................................. 5!
2.2. The Power of the Index Provider ................................................................................... 6!
3. Risk Potential for Financial Markets ..................................................................................... 7!
3.1. ETFs Lead to Market Inefficiency ................................................................................. 7!
3.2. Competitive Distortion with Sector ETFs ...................................................................... 7!
4. Special Role of ETF Provider ................................................................................................ 8!
4.1. Proxy Voting Rights ....................................................................................................... 9!
4.2. Potential Abuse of Power for ETF Provider .................................................................. 9!
4.3. ETF Provider Legislation in Germany ......................................................................... 10!
4.4. Lobbying of ETF provider ........................................................................................... 11!
4.5. Positive Effects on Corporate Governance .................................................................. 12!
5. Conclusion ........................................................................................................................... 13!
References ................................................................................................................................ 15!
ETFs and its Risk Potential
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1. INTRODUCTION
In this paper will I discuss the risk potential of Exchange-Traded Funds for the
financial markets in general and for the investors in specific. Following the definition of ETFs
and an outline of other Exchange-Traded Products, I will focus on the risks that those
products have or could have for an investor and, because of its popularity beyond small and
private investors, I will pay special attention to common misconceptions of passive investing.
In the subsequent section I will investigate briefly the effects on financial markets and its
stability before I will highlight potential problems that might arise, caused by ETF providers.
When writing about ETFs in this text, I am referring to physically backed-up ETFs unless
stated otherwise.
1.1. Definition of ETFs
Exchange-Traded Funds (ETF) became more and more popular in the past. For private
investors willing to invest in the market as a whole there were in general two ways before
ETFs were developed. On the one hand side, one could buy one share of each company of an
index as a market proxy, that would be for the leading index in Germany DAX30, buying
thirty shares. But this portfolio would not track the DAX30, because this index is a weighted
index. “The weighting of a share in the index is determined on the basis of market cap of
shares in free-float.” With a maximum weighting of 10% of one individual share (STOXX,
2015). To now replicate this index one simply has to follow this weighting e.g. 10% of the
portfolio invested in Bayer AG; 3.46% of the portfolio invested in BMW AG etc. The index
composition changes annually and the weighting is adjusted quarterly meaning that the
investor would need to follow these changes continually. For the investor that already leads to
two obstacles that makes an investment following an index as a market proxy not feasible.
First, to fully replicate the index one needs to buy a high amount of shares since one cannot
buy a fraction of a share. Second, every change in the composition and weighting of the index
needs to be tracked and replicated and for every change this means fees for buying and
selling.
To overcome these obstacles, mutual funds have been designed that follow the
performance of an index called index funds. For their service of tracking the index, mutual
funds require a fee that includes sales and redemption fees (Berk & DeMarzo, 2014, p. 405).
An ETF has the same intention as an index fund but with several advantages. The first
advantage is its liquidity as it is traded throughout a day like a normal stock and it is treated
like a normal stock allowing the investor to buy derivatives on an ETF. Secondly, its
transparency is one major advantage as ETFs offer daily disclosure of holdings, allowing the
ETFs and its Risk Potential
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investor to actually know what he or she is owning. And finally there are some cost
advantages over an index fund including certain tax advantages (see figure 1 for a
comparison).
Figure 1. Summary of Cost Comparison. Source: (Kostovetsky, 2003)
ETFs are a subgroup of Exchange-Traded Products (ETP) next to Exchange-Traded
Notes (ETN), Exchange-Traded Commodities (ETC) and more. All of these ETPs are also
available as inverse products or leveraged products. Additionally, one can, in general,
differentiate between a physically backed-up ETF (or real ETF) and a synthetical ETF where
the index performance is replicated with derivatives which are not necessarily derivatives of
the index comprising stocks.
Exchange-Traded Dividends (ETD), although having a similar name actually do not
qualify for being an ETP because they do not track an index and do not share other
characteristics of ETPs, they are rather future contracts where the right to receive a dividend
for a share is sold to a third party, but for the matter of completeness it should be mentioned
here especially because it will be discussed later in this paper again.
1.2. History and Development of ETFs
One reason for the increasing popularity of ETFs is that many researcher have shown
that actively managed funds on average cannot beat the benchmark (index) when subtracting
the management fees (Johnson, Bryan, Boccellari, & Rawson, 2015). For an average investor
it is difficult and time consuming to identify a share that one should buy to build up a
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portfolio, therefore mutual funds offer this service of preselected portfolios intended to beat
the benchmark.
Mutual funds were initially created 1774 in the Netherlands to allow a group of
investors for cash pooling. In the year 1975 index funds were created and in 1990 the first
ETF was designed (Investopedia.com, 2015). These relatively new investment opportunities
became more and more popular since invention (see figure 2) and the ETF market today
(2015) has a volume of close to $3 trillion with two-digit organic growth rates (without price
appreciation) in the past (Deutsche Bank, 2015).
Figure 2. Development of Assets Under Management in ETFs. Source: (Deutsche Bank, n.d.)
The reasons for the increasing popularity are numerous starting with research
conducted already in the 1970s indicating that actively managed mutual funds are mostly not
able to beat the benchmark (index) on average over time (Calderwood, 1977). Since then it
seems like a narrative that it is not possible to beat the benchmark, supported by the efficient-
market hypothesis (EMH) developed by Eugene Fama 1970 and reinforced by Kenneth
French in 2012 that became very popular beyond professionals. This view on financial
markets spread quickly beyond private investors who then saw no benefit of grappling with
the, for some people, mysterious world of financial markets. It is just mentally easier to buy
ETFs and its Risk Potential
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the whole market and realize the average return than trying to beat the market with the risk of
making wrong decisions and ending up worse than the average. Especially when looking at
the past when the S&P 500 index resulted in a compounded annual gain of roughly 10% in
the years 1964 - 2014 (Warren Buffet, 2014, p. 2), it seems not worthwhile to engage in
stock-picking. Furthermore, index developments of the major indices like DowJones,
EuroStoxx, Dax30 etc., are well covered by the media unlike single stocks which are
mentioned only when sudden price increases or (more often) decreases occur.
Many financial advisors nowadays publicly recommend in investing in ETFs. Even
Warren Buffet, famous for being able to beat the market for 39 out of 49 years (as of 2014)
wrote in the annual report 2013 of his company Berkshire Hathaway, as an advice to the
trustee of his cash reserves (in favor of his wife) in case of his death:
“My advice to the trustee could not be more simple: Put 10% of the cash in
short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I
suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be
superior to those attained by most investors – whether pension funds, institutions or
individuals – who employ high-fee managers.” (Warren Buffet, 2014, p. 20)
Additionally, it is very easy to compile a worldwide diversified portfolio by simply
buying a few ETFs and to diversify away country specific risks, currency risks and company
specific risks. With other Exchange-traded products (ETP) it is even possible to diversify the
asset class risk very easily.
Given all these benefits of ETFs e.g. low cost, diversification, liquidity, and ease of
investment one has a hard time arguing against these investment products. But normally when
something seems to be too good to be true, it normally isn´t.
2. RISKS FOR INVESTORS
Many private investors nowadays avoid actively managed portfolios and financial
advisors as they are seen to be too costly and not superior than the market. In fact, the rise of
the internet and availability of direct broker lead many small private investors to directly
invest in assets. Additionally, the governments of many countries enforced the private
retirement planning with actions like the 401(k) in USA. In earlier times when interest rates
were up, many of these investors invested in bonds and especially government bonds. The
idea behind a bond is easy to understand as it is like giving a loan to an entity and receiving
reliable interest rates every period, the risk is determined by a rating from a rating agency like
Moody´s and is very easy to understand even for somebody not at all interested in the
financial markets. A triple A rating (AAA) for example means low risk and together with the
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attached interest rate that are all information a small investor needed. Nowadays, the interest
rates are low and sometimes negative and do not qualify for a retirement saving anymore.
Therefore, many private investors shift their investments in equity classes. For a non-
knowledgeable investor there is no easily observable interest rate anymore and no rating
either. In 1996 the Deutsche Telekom AG ran commercials promoting their shares as
“Volksaktie” (people´s share), targeting small private investors. The marketing was successful
and as a result the share sky rocketed until the burst of the dotcom bubble (Figure 2).
Figure 3. Share Price of Deutsche Telekom AG. Source: Deutsche Telekom AG retrieved 7th
October 2014
Today, it seems that stock picking, at least in Germany, is out of fashion. The new
trend seems to be to invest in ETFs, because of all their benefits towards a classical mutual
fund. In the following section I will focus on the risks for private investors in investing in an
ETF.
2.1. A False Sense of Security: Stop-loss Orders
The idea behind stop-loss orders is to sell an asset when the prices of it declines
rapidly. Many investors have a trailing stop-loss order of five percent meaning that if the price
of the asset declines in the specific period, normally intraday, the asset is sold to the market
maker who sells the asset again to the market. The market maker has in general the role to
take care of liquidity. In the hypothetical example, where 80% of the market member in an
index have a trailing stop-loss order of five percent and the index declines of more than five
percent, the market maker would have to buy huge amounts of shares without being able to
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ETFs and its Risk Potential
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sell the shares quick enough to not be insolvent. In this case several stop-loss orders cannot be
executed anymore. If the index continues to decline the investor still owns the share even
though he or she has the expectation that the share has automatically been sold with a five
percent discount. In the meanwhile, the bid ask spread determined by the market maker
widened to a 50% discount and in the worst case the stop-loss order is still active and will be
executed at a 50% discount instead of a 5% discount. Shortly after, the index stabilized and
the bid-ask spread normalized. It would have been better for the investor to just not execute
the order at a 50% discount but to wait until the index stabilized. In this scenario, the 5%
stop-loss order did exactly the opposite of what its intention has been, namely to prevent the
investor of too high losses. If the investor now relies blindly on this order and believes to be
on the save sides, since he or she holds a diversified portfolio and the stop-loss order protects
them, it can lead to an overinvestment into ETFs and in the worst case to a loss of retirement
savings.
2.2. The Power of the Index Provider
The power of index provider on the market increases in the same fashion as ETFs
become more popular. Normally, the composition and weighting of indices follows a very
strict and transparent structure. The market capitalization, free float, trading volume and some
qualitative factors like location or industry are the important factors for being in or out of a
specific index. For bigger and more prominent indices the reasons for being in the index are
easily observable and not based on human judgment. On the other hand, no one can prevent
somebody from developing an own index, for example a sector index. A sector index is
usually focused on just one specific industry like telecommunication, car producer or
financial institution. Now for somebody willing to develop a sector index it is quite difficult
nowadays to specify the industry a company is in. For example, VW and BMW seem to be in
the same industry which is car producing. Now it sounds reasonable to put both in the same
“car sector index”. BMW however also produces bicycles and VW also produces busses and
trucks which are very different industries when it comes to customer markets. For the index
provider this means a certain level of freedom on how to build up the sector index and this
freedom can also be considered power. If now an ETF provider wants to offer a new sector
ETF for cars to allow its customer to buy only “the car industry”, the provider will replicate
the index the index provider composed, which makes the index provider indirectly a mutual
fund manager, without the responsibilities and regulation. For knowledgeable investors and
professionals this risk is limited, but for small investors directly buying those products
without advice it is not.
ETFs and its Risk Potential
7
3. RISK POTENTIAL FOR FINANCIAL MARKETS
In the following section I will investigate some potential problems that might arise
with ETFs on financial markets and its stability. I will argue that passive investing with a
periodical investment plan causes market inefficiencies and in the second part, that sector
indices could cause competitive distortion.
3.1. ETFs Lead to Market Inefficiency
Many small investors use an investment plan where they invest a fixed amount of
money periodically in ETFs. This leads to the situation that shares are bought regardless of
their inherent value as long as they are in the ETFs’ underlying index. This demand for the
share drives its price up although the financial situation of the company would not support a
buy. This in the end leads to an overvaluation of the company, which is not a big issue for the
financial markets. However, when one sees an ETF as a share of a company and this
“company” is overvalued, we are already talking about market bubbles which have an effect
on the stability of financial markets. If the price of an asset is too far away from its intrinsic
value than this asset is regarded overpriced and if the price of an ETF is too far away from the
intrinsic values of its comprising assets it ends up in a market bubble. For the efficient market
hypothesis (EMH) to work, assets need to be fairly priced, this is not the case if the demand
for a share continuous although no new information have been assessed. But for an ETF to
work, the market needs to be at least semi-strong efficient otherwise increasing ETF prices
are a self-fulfilling prophecy. In absence of regulating mechanisms that ensure the efficiency
of the market, like equity analysts, the price for ETFs rises and by that the historical returns of
the ETF which attracts even more investors to invest in the ETF. This spiral goes on until it
will suddenly stop sooner or later and end up in a market crash.
Furthermore, two companies listed in the same index are treated equally as if there
wouldn´t be quality differences. For example, company A and B are both listed in an index
with an equal weighting, company A is highly profitable and steadily growing and can be
considered less risky, whereas company B is not at all profitable, badly managed and highly
levered. For an ETF investor this is irrelevant as he or she would buy both companies to any
given price just because both are listed in the same index with equal weighting.
However, up to now the markets still seem to work normally although the number of
financial analyst active in the markets declines as the demand for them declines since more
and more cash is pooled in ETFs rather than mutual funds.
3.2. Competitive Distortion with Sector ETFs
ETFs and its Risk Potential
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The very essence of a sector index is to buy similar companies active in the same
market. If now ETFs buy shares of a sector index, this ETF is simultaneously owner of two or
more competing companies. A recent study investigated potential negative effects of common
ownership on competition and found out that prices for airline tickets increased while the
amount of passengers decreased (Azar, Schmalz, & Tecu, 2015). Although, the research
showed just a sign of reduced competition and no empirical evidence for the market as a
whole, it is logically sound that the owner of two or more competing companies has no
incentive for competition. The influence of the ETF provider on the company obviously
depends on the share it has in the company, but since all ETF provider investing in a sector
index have the same incentive of reduced competition, it is hard to believe that the ETF
provider will not execute the cumulated power to reduce competition in the sector. This risk
of reduced competition increases the more specific and narrow the index is defined.
Competition guardians normally overlook mergers and acquisition and have an incentive of
ensuring competition. So far, however, there is no effective regulation to avoid the above
mentioned potential problem resulting from sector indices and its ETFs.
4. SPECIAL ROLE OF ETF PROVIDER
In this section I will focus on potential risks that come along with ETF providers with
a special attention on the biggest provider BlackRock. The magnitude of cash pooling is new
and so are the problems and potential impact that go along with the risks. The amount of
assets under management increased dramatically in recent years, with two-digit organic
growth rate heading for three trillion US Dollar in 2016. The three biggest provider of ETFs
are BlackRock with $1,110 bn and a market share of 37%; Vanguard $494 bn and 16.5%
market share; State Street $448.5 bn and 15% market share. This totals in roughly $2 trillion
assets under management for the three biggest providers alone and a global market share in
the ETF market of 68.5% (see figure 4).
Figure 4: Table. Market Share of ETF provider as of April 2015. Source: Forbes.com
ETFs and its Risk Potential
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Given this huge amount of cash pooled just in three funds results in a concentration of
power which is new to the financial system. The power does not stem from the providers´
ability to choose investments, because they have no influence on this decision, but from the
power of voting rights.
4.1. Proxy Voting Rights
When buying a physically backed-up ETF the ETF provider buys the shares of the
index. The shares not only give the right to receive financial benefits from the issuing
company like dividends and price appreciations, but also voting rights. However, the
purchaser of the ETF just buys the financial benefits and risks of the underlying shares, but he
or she is not the direct legal owner of these shares. Specifically, the ETF owner has not
bought the voting rights that he or she would have if he or she would have bought the shares
on their own. Indeed, the ETF provider who bought the shares keeps the voting rights and just
passes on the financial benefits and risks of the shares to the ETF purchaser. The ETF issuer
uses these proxy voting rights now on behalf of the ETF purchaser. As the intentions of the
ETF holders are unclear, the ETF provider publishes guidelines on its probable voting
behavior (BlackRock, 2012, 2015).
BlackRock makes it very clear on what their focus is when executing their power and
that is the value of their clients’ assets as they promote on their website “As a fiduciary asset
manager, we have a duty to act in our clients' best interests. This includes protecting and
enhancing the value of our clients’ assets—that is, the companies in which we invest on their
behalf—by promoting good corporate governance.” (BlackRock, 2016). Nevertheless, albeit
pretending to have positive effects on the corporate governance, the risk of abusive behavior
once the power seems to be unassailable, is real. “With great power comes great
responsibility” (Spider-Man, 2002).
4.2. Potential Abuse of Power for ETF Provider
The number of ETF provider is continuously growing. It is likely that not all ETF
provider will behave ethical or responsible in the future. The following hypothetical scenario
will illustrate a potential fraudulent action undertaken by an ETF provider (or alternatively by
a single investor with equal power). This fraudulent action requires three steps.
The first step is to buy enough shares in a dividend paying company to influence the
management of this company. For ETF provider, these voting rights are free of charge as
discussed in the previous section of this paper.
In the second step, the ETF provider sells now the rights to receive a dividend via
futures contract on the market. By that the ETF provider receives the value of the dividends at
ETFs and its Risk Potential
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the future date. These so called Exchange-traded Dividends are not to be confused with ETP
because they just share the naming not the structure or intention.
The third and last step is now to execute the voting rights and convince the
management not to pay out any dividends and instead to buy back shares in the same amount
as the dividends. This has no effect on the value of the company therefore the owner of the
ETF is not worse off than with dividend payments but the ETF provider made an additional
profit by selling the ETDs. If the ETF issuer has enough voting rights to reliably convince the
management, then there is an arbitrage opportunity for the provider. The wronged party is the
buyer of the ETD, while the ETF holder may not even notice this activity. For this scenario to
work out, it is not necessary to buy the whole index and convince every manager to buy-back
shares. It would already be possible with just one company under the cover of an ETF.
Although, this might seem illegal, and it probably is, this is the very core of fraudulent
activities in the capital market. Up to now the ETF market has been spared from any criminal
activities, but the ETF market is still relatively young. Furthermore, given a certain level of
power that many ETF provider clearly have, it is not even necessary to convince the
management actively to repurchase shares instead of paying out dividends, this provider just
has to state it on their proxy voting guidelines. So far, BlackRock is silent about a preferred
dividend payout policy in their proxy voting guidelines, but fraudulent ETF provider may use
this scenario to improve their profits.
4.3. ETF Provider Legislation in Germany
In Germany the Securities Trade Act (Wertpapierhandelsgesetz WpHG) regulates
when an investor has to publish information on his or her voting rights. According to § 21
para. 1 WpHG
“(1) Any party (the party subject to the notification requirement) whose shareholding
in an issuer whose home country is the Federal Republic of Germany reaches, exceeds or falls
below 3 percent, 5 percent, 10 percent, 15 percent, 20 percent, 25 percent, 30 percent, 50
percent or 75 percent of the voting rights by purchase, sale or by any other means shall (…),
notify this to the issuer and simultaneously to the Supervisory Authority (…)”
In compliance with these law BlackRock has to notify the BaFin (Federal Financial
Supervisory Authority) if the accumulated voting rights attributable to BlackRock as a
company, not to a specific ETF product, exceeds a certain threshold. The threshold mentioned
in the Securities Trade Act are selected according to the voting power steps, meaning that
with 3 percent according to the law, BlackRock already has enough power in a company to
influence the management. Violations of this law can become costly as BlackRock already
ETFs and its Risk Potential
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learned. On the 20th of March 2015, BaFin imposed a fine of €3.25 million on BlackRock,
because of violations of the previously mentioned law (BaFin, 2015). Since then no more
violations on §21 WpHG happened by BlackRock.
On the 1st of October 2014 BlackRock reported that they now own 4.94% of the
voting rights of ProSiebenSat.1 Media AG which is a German mass media company. Roughly
one year later on the 13th of July 2015 Black Rock reported that they now own 8.05% of the
total voting rights of this company. If they keep this pace, and do not close the ETFs that
these shares are attributable to, then BlackRock needs to make a take-over bid before they
reach 30% of voting rights, according to Germanys Acquisition and Takeover Act (§ 29
Wertpapiererwerbs- und Übernahmegesetz, WpÜG). The thirty percent threshold is
considered controlling interest in the company (§ 29 para. 1 WpÜG). How this take-over bid
will be processed remains unclear until BlackRock or another ETF provider reaches this
threshold. However, the amount of voting rights pooled in one company releases some
concerns.
Take-overs of listed companies take place on regular basis and are no issue at all for
financial markets in general. However, ETFs are intended to buy an index and not just one
company and depending on the structure of the index, it could happen that one ETF provider
has to make take over bids for the whole index stepwise in a short period of time. In this, up
to now, hypothetical case of an index take-over the impact on financial markets is unclear.
Another issue that has been recently discussed by investors like Carl Icahn
(Whitehouse, 2015) and researches (Massa, Schumacher, & Wang, 2015),is the effect of
ETFs and ETF issuer on the liquidity of stock markets in a crisis situation.
4.4. Lobbying of ETF provider
For an ETF provider to attract more customers, it is essential that the underlying index
performs well. If the index would decline over several years, investors would redeem their
investments and shift to other forms of investments. When looking at the shareholder
structure of some companies listed in an index one usually finds ETFs as one of the most
important shareholders. For BlackRock as one of the biggest ETF provider and by that
shareholder of the biggest German companies, it has an incentive to influence the whole
German market to ensure the performance of the index.
One important factor for the index is the monetary policy in the European Union. In
the last years, subsequent to the financial crisis in 2007 / 2008, the European Union
intensified their use of monetary policy. Keeping interest rates low means that more money is
shifted out of the bond market and into the equity market which leads to price increases for
ETFs and its Risk Potential
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equity products. Now, BlackRock and others have a high incentive to execute their power and
to influence the monetary policy. For equity investors that is a good thing since this influence
pays off for all equity investor, regardless of being a customer of BlackRock or not. For non-
equity investors or generally non-investors this influence on policy can also have negative
effects. Keeping interest rates low means for example that private debt is also very low, for a
person willing to buy real estate it is tempting to buy it when the interest rates are cheap and
look affordable. Consequently, many private persons buy real estate, which drives the prices.
Usually the mortgage loan interest rate is fixed for ten to fifteen years and after that will be
renewed to the new interest rate level. Many new homeowners ignore the effects of increasing
interest rates in the future, although it is highly likely that interest rates will increase sooner or
later. In the case where interest rates for mortgages would double from now roughly 2 per
cent annually to 4 per cent annually in ten to fifteen years’ time, it would mean that many
small homeowners will have difficulties refinancing their houses, forcing some to sell the
houses. If this happens on a large scale the supply for houses increases rapidly in a short
period of time which decreases housing prices leaving other homeowners with less security
for new mortgage contracts. This spiral already happened in the financial crisis 2007/ 2008 in
the US American housing market and is likely to happen again in other countries if the
interest rates go up.
All in all, influencing policies has positive effects on the lobbyist group, but not
necessarily on other stakeholders effected by the lobbying activity.
4.5. Positive Effects on Corporate Governance
Although many criticism and concerns arise when talking about ETFs, there are also
positive effects on the financial market and for investors. One could categorize these effects
in three parts, the first positive effect may be on the long term perspective of passive
investing, the second on the actual pooling and execution of voting rights and the last on the
corporate governance of a company in general.
Positive effects on the long term investment perspective of passive investment forms
like ETFs may stem from the investors observable willingness to keep the share over the long
run and not interested in short-term profit. For the management of a company it is difficult if
not impossible to know or estimate the intention of the investor if this investor just holds a
small share of the company. By voting rights pooling together with predefined and published
voting habits and intentions, which is usually the case for ETF provider, the management has
a much clearer view on the intention of the investors than it would be the case with many
different small investors. The intention of the ETF provider and its voting habits are usually
ETFs and its Risk Potential
13
long-term oriented, since there is no incentive for the provider to quickly profit from the
investment on the cost of long term development.
The second positive effect on corporate governance is the pooling and execution of
voting rights. A small investor with just a few shares in a company is unlikely to attend an
annual meeting of the company, by that he or she will not execute the voting rights. For
companies that have many small investors it could mean that if just 25% of the shareholders
execute their voting rights then this would make the voting rights of the ones who execute
their voting rights four times more powerful. ETF provider in general use their proxy voting
rights by that increasing the number of votes and reducing the above mentioned effect in
annual meetings. This makes it less easy for activist investors to enforce a selfish will that is
not in the best interest of the company
The third effect is the positive effect on the corporate governance of companies
throughout a market in general. By executing their voting rights and coherently following and
enforcing certain corporate government principles, ETF provider can ensure that the
management of the company is well monitored and their behavior is more compliant to
corporate governance standards. Certainly, that depends on the corporate governance
guidelines and its enforcement by the ETF provider, but a recent study already examined
potential positive effects on corporate governance by passive investors like ETFs, and their
findings suggest that:
“(…) passive mutual funds influence firms’ governance choices, resulting in more
independent directors, removal of takeover defenses, and more equal voting rights. Passive
investors appear to exert influence through their large voting blocs, and consistent with the
observed governance differences increasing firm value, passive ownership is associated with
improvements in firms’ longer-term performance” (Appel, Gormley, & Keim, 2014).
These findings raise hope that ETFs on the long run will have positive effects on
corporate governance, but more research on the topic is necessary.
5. CONCLUSION
The increasing popularity of ETFs has its rational reasons, but it comes with a price.
As discussed in this paper, the amount of asset under management pooled in just a few asset
management companies inherent risk that are not clearly observable up to now. But it remains
a threat to the stability of the financial markets if this immense power is misused. For private
investors the development of ETFs are both positive as well as negative. On the positive side,
ETFs have increased competition beyond mutual funds and by that lowered prices.
Nevertheless, now that many private investors directly invest in ETFs, it increases also the
ETFs and its Risk Potential
14
risks for the private investor. The increasing power of index provider and the growing amount
of ETPs makes it more difficult for regulators to react on the recent changes in the capital
markets. New opportunities to invest, normally also attract fraudulent behavior of investors
who seek for loopholes. But as has already be mentioned in the text, ETF provider can even
have a positive effect on corporate governance on a large scale. Whether the positive or
negative effects prevail is up to now rather a question of belief than fact and more research
has to be conducted on this topic.
ETFs and its Risk Potential
15
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