Violent downturns could test new ETF strategies, warns MFS Investment

New innovation in the exchange-traded fund industry could come at a cost to investors during extreme conditions.

According to MFS Investment Management’s Jamie Harrison, ETFs involved in increasingly complex derivatives and less transparent markets may be in uncharted territory when it comes to violent downturns.

“Those would be something that you’d want to keep an eye on as volatility ramps up,” the firm’s head of ETF capital markets told CNBC’s “ETF Edge” this week. “As innovation continues to increase at a rapid pace within the ETF wrapper, [it’s] definitely something that we advise our clients to be really front-footed about… Lack of transparency could absolutely be an issue if we’re going to start seeing some deep sell-offs.”

His firm has been around since 1924 and is known for inventing the open-end mutual fund. Last year, ETF.com named MFS Investment Management as the best new ETF issuer.

“It’s important to do due diligence on the portfolio,” he said. “Having a firm that has deep partnerships, deep bench of subject matter experts that plays with the A-team in terms of the Street and liquidity providers available [are] super important.”

Harrison suggested the real issue is liquidity, particularly during a steep sell-off.

“We’ve all seen the news and the headlines around potential private credit ETFs. That picture becomes much more murky,” he added. “It’s up to advisors, to investors [and] to clients to really dig in and look under the hood and engage with their issuers.”

He noted investors will have to ask some tough questions.

“What does this look like in a 20% drawdown? How does this liquidity facility work? Am I going to be able to get in? Am I going to be able to get out? And if I’m able to get out, am I able to get out at a price that’s tight to NAV [net asset value], and what’s the infrastructure at your shop in terms of managing that consideration for me,” said Harrison.

Amplify ETFs’ Christian Magoon is also concerned about these newer ETF strategies could weather a monster drawdown. He listed private credit as a red flag.

“If your ETF owns private credit, I think it’s worth taking a look at, kind of what the standards are around liquidity and how that ETF is trading, because that should be a bit of a mismatch between the trading pace of ETFs and the underlying asset,” the firm’s CEO said in the same interview.

Magoon also highlighted potential issues surrounding equity-linked notes. The notes provide fixed income security while offering potentially higher returns linked to stocks or equity indexes.

“Those could potentially be in stress due to redemptions and the underlying credit risk. That’s another kind of unique derivative,” Magoon said. “I would very closely look at any ETF that has equity-linked notes should we get into a major drawdown or there be a contagion in private credit or something related to the banking system.”