The negativity surrounding ETFs has been from those who stand to lose the most – active managers, Arian Neiron writes.
Exchange traded funds (ETFs) have grown to become an increasingly popular investment vehicle for Australian retail and institutional investors. The sharp rise in their popularity has attracted funds under management (FUM) of $27.4 billion as at 31 August.
Despite their success, or likely because of it, there are a number of myths being spread about ETFs.
Some commentators argue ETFs will be the cause of the next bubble and are leading the financial world to ruin. Others have even called them a ‘Ponzi’ scheme.
This article provides the facts behind ETFs and busts some of the common myths that exist today.
Myth 1: ETFs are a fad
ETFs have, in fact, been on the scene for almost 30 years. The world’s first ETF was launched in Canada in 1990, and the first ETF listed in the US in 1993. Institutional investors were the first backers of ETFs and retail investors have been buying up ETFs since the early 2000s.
The rise of ETFs is part of the rise of passive investing. ETFs are passive funds that are traded on an exchange such as the ASX. They aim to track an index, in contrast to active funds, which seek to outperform a benchmark index.
The rise of passive investing since the Global Financial Crisis (GFC) has coincided with a significant decline in investor appetite for active investing. This has led to the situation where flows to passive funds far exceed flows to active funds, as the chart below indicates. This is no fad but in fact a huge consistent movement that has developed over time.
Myth 2: ETFs are riskier than managed funds
ETFs are designed to replicate the performance of an index. Standard or ‘physical ETFs’ buy the underlying investments (such as stocks and other securities) that are in the underlying index. The fund owns the assets outright.
If you invest in an ETF, you will own units or shares in the ETF just like managed funds. But your main investment risk remains the performance of the underlying assets, that is, the risk that the value of the assets will rise and fall in line with index market movements.
In the same way, the main investment risk with a managed fund arises from the investment risk related to the assets the fund holds. All else being equal, an ETF is no more or less risky than a managed fund.
Myth 3: All ETPs are ETFs
There are many new types of exchange traded products (ETPs) coming to the market that are not ETFs. Products labelled ‘exchange traded managed funds’, ‘quoted managed funds’, ‘exchange traded commodities’, ‘exchange traded notes’, ‘exchange traded certificates’, or ‘exchange traded securities’ are not ETFs.
A key feature of ETFs is the transparency of their portfolio holdings, which are reported daily.
Myth 4: ETFs are for short-term investors
A common myth is that ETFs are short-term trading instruments only. But like any listed security, ETFs can be bought on an exchange and held for the long-term. There is no fundamental reason why they should be held only for the short-term.
Retail investors and self-managed superannuation funds (SMSFs) have long been buying ETFs to diversify and position their portfolios to achieve particular investment outcomes. There are a range of ways ETFs can be employed in portfolios, including long-term strategic asset allocation and tactical investing. Another popular strategy is using an ETF as a core strategy and adding individual positions, or satellites, around that core.
Myth 5: ETFs create bubbles and inefficiencies
Another common claim is that ETFs are creating the next ‘bubble’ and will be responsible for market inefficiencies and volatility. The argument is that ETFs are driving up stock prices regardless of their fundamental value.
This is a myth. In Australia, ETFs do not own enough of the stock market to move it in any meaningful way. The ASX’s total stock market value is $1.7 trillion, up from $1.5 trillion dollars in 2012.
In that time ETFs grew from $10 billion in 2012 to be around $30 billion today of which only 42 per cent is invested in Australian equities. Even though ETFs have tripled in size, they still only represent 1.7 per cent of the stock market.
The fact is, volatility in share markets is driven by macroeconomic factors such as gross domestic product (GDP), inflation and interest-rate movements rather than the buying or selling of underlying assets by market makers. Indeed, share market volatility has been a characteristic of markets well before ETFs emerged.
Myth 6: ETFs impact market liquidity
Even though ETFs only own six per cent of US equities, they account for around 30 per cent of the trading volume – double what it was 10 years ago.
Bloomberg claims this could present a problem “if more and more people stop trading stocks and bonds in favour of ETFs, it will drive up trading costs in the underlying securities while potentially making it more difficult to exit on big sell-off days”.
But currently in Australia ETFs represent just 2.5 per cent of trading volume. This is nowhere near enough to distort the economics of trading.
Myth 7: ETFs inefficiently allocate resources
Another criticism of ETFs is that because of their disproportionately large flows, ETFs have been distorting the market by buying stocks that active fund managers wouldn’t necessarily buy. Table 1 and Table 2 illustrate that active funds are buying the same stocks as the market capitalisation index in relatively similar proportions.
The hysteria about ETFs is based on myths. ETFs are not creating a bubble nor are they inefficient or significantly distorting the market. Much of the negative focus on ETFs has been written by those who stand to lose the most, that is, active fund managers.
Arian Neiron is the managing director of VanEck Australia.