ETF – Three Letters That Have Changed the World

7 August 2017  |  Adam French
 ETF – Three Letters That Have Changed the World
John C. Bogle was derided by colleagues when he first conceived the idea of an ‘index fund’ in 1976.
With an estimated $4 trillion globally in Exchange Traded Funds today, it looks like Bogle has the last laugh. Here we discuss how they have changed investing for the better.

In 1976, John C. Bogle conceived an idea very close to that of the index fund we know today. It was called ‘Bogle’s folly’ at the time and labelled a preposterous idea. He was mocked by colleagues over his preference to replicate the S&P 500 instead of selecting individual stocks and bonds.

But Bogle continued his campaign to bring index funds to the nation. The transparency and low costs associated with the product seemed to bring great benefits to the investor. In the end, his colleagues tired of arguing with him and relented. We now know that his idea was far from preposterous and today Bogle is often described as a genius.

At the time, Bogle believed that no one, not even the very best stock-picking expert, could know with clarity which stocks were going to outperform the overall market. Countless empirical studies conducted since have confirmed his assertion. It now looks likely that in just a few years time, there will be more money invested in passive funds than in active.

A Fast-Paced Chase

Share of active and passive equity investments worldwide (in %)

Share of active and passive equity investments worldwide (in %)

Source: BofA Merrill Lynch Global Investment Strategy, EPFR Global

Exchange Traded Funds (ETFs) have descended from Bogle’s original ideas and are frequently discussed alongside index funds. Their low costs and high transparency set the product apart. They are traded daily on the stock exchange, in the same way stocks and bonds are, but follow an index. For example, if the FTSE 100 rises by one percent, the corresponding ETF also rises at the same rate.

Investors benefit from the easy diversification that ETFs allow. An index fund that tracks the S&P 500 allows exposure to 500 companies with just one transaction. The MSCI World Index represents the most significant shares from 23 industrial countries and contains roughly 1,650 individual companies. The risk of an ETF tracking this index will be very broadly spread and investors would struggle to spread their risk so widely were the ETF structure not to exist. An investor with £10,000 to invest in the MSCI World would end up with exposure of, on average, £6 to every company (before taking additional costs into account).

Disappointed Bankers

Bogle wanted to raise $150 million for his first index fund – originally called Index Investment Trust – but his expectations were disappointed when investors contributed just $11.3 million. The investment bankers responsible for launching the fund were so disappointed that they wanted to close it. “Hell no”, said Bogle at the time. And thank goodness he did. That investment vehicle still exists although it is now known as the Vanguard 500 Index Fund and its AuM runs into the billions. Those who believed in Bogle and his ideas from the start would now be sitting on an increase of almost 2,300 percent. The returns of most active funds pale in comparison.

The performance of the Vanguard 500 fund illustrates how a long-term investment in equities can really pay off. When looking at the long-term overview of the S&P 500, the bursting of the dot.com bubble, the terrorist attacks of 9/11 and the financial crisis of 2008 seem nothing more than small hiccups in a steep upwards curve. Those in it for the long run will emerge victoriously.

Stock Picking and Painful Losses

According to figures from BlackRock, the largest provider of ETFs in the world, there was just $79 billion in index funds in 2000. But after the hard lessons learnt during the dot.com crash, investors began to look for a new way to invest. Their long-relied upon method of stock picking had led to painful losses.

This realisation eventually led to a flow of over $500 billion into ETFs by 2006. The 2008 financial crisis was responsible for the final push for passive and in 2009, there was over $1 trillion in ETFs. Four years later this figure had reached $2 trillion. BlackRock expects the figure to be close to $7 trillion by 2020.

Post-Financial Crisis Increase

Managed ETF assets worldwide (in trillions of dollars)

Managed ETF assets worldwide (in trillions of dollars)

Source: BlackRock

The reason for this stratospheric rise is simple: ETFs are suitable for all types of investors. They are easy to buy and sell, low cost and broadly diversified. But it remains important for investors to understand their most important features before purchase. There are a lot of ETFs in the market – over 1,500 in the UK alone, and choosing the right one for you may not be as straightforward as originally anticipated.

The most important points to consider are:

Costs: The fees for ETFs are much lower than those of actively managed funds. After all, ETFs ‘simply’ replicate an index; they do not need a fund manager to filter stocks. This lower fee is a huge advantage for investors as costs can really eat into returns. To read more about this, please refer to our blog post; The Labyrinth of Fees.

To find out the cost of an ETF, look for the Total Expense Ratio (TER), also known as the total cost ratio. This will give you an indication of the price of the ETF, but misleadingly, it does not actually include all costs. Additional costs will include trading and custody and if you buy from a platform there will likely be further charges there too. To give you an indication though, the TER for equity indices ETFs should not be more than 0.2 – 0.5 percent.

Liquidity: ETFs are very liquid investment products. Their daily trading on an exchange ensures that investors can trade their shares much more quickly than they could classic investment funds (which are only usually priced once per day). There are occasional limitations on liquidity but only in the most extreme cases. For example, some high-yield indices sometimes contain illiquid components which means that investors may struggle to trade their ETF shares at a reasonable price and exactly at the time they want, via the stock exchange. This can be a problem, especially when the markets crash.

Replication method: Physical vs. synthetic. When it comes to ETFs, investors will find that there are broadly two types of replication, both have their own merits. Physical replication means that the actual securities underlying the index are bought by the ETF provider.

A synthetically replicating ETF refers to an index fund that uses swaps with counterparties to replicate the index, rather than buying the underlying assets themselves. This means that they are exposed to counterparty risk, which became an issue during the Financial Crises when several banks that acted as counterparties for those derivative contracts went bankrupt. Some indices, such as certain commodities indices or Emerging Market indices can only be replicated synthetically as the investor cannot buy their underliers physically; an example could be crude oil. To read more about this, please refer to our blog post; Physical vs. Synthetic ETFs.

Tracking error: Just like painting; creating an exact copy of anything is not that easy. The accuracy of the replication is measured by the ‘tracking error’. The higher the tracking error, the greater the deviation. Physically replicated ETFs typically have a higher tracking error than those that have been synthetically replicated. Accounting for fees and taxes causes further deviation from the index.

The ETF Revolution

ETFs have revolutionised private investing. Everyone is now able to invest across a broad range of assets at a low cost and with whatever amount they can afford. The difficulty comes from reviewing the thousands of ETFs in the market and choosing which ones are the most suitable for you. After all, a portfolio that consists of just one equities ETF contains too much risk for most investors, so they need to combine several ETFs to match their individual risk tolerance. Finding the right combination and adjusting the portfolio allocation over time to make sure its risk profile doesn’t change over time isn’t a trivial task.

To save time, and money, it would be wise to approach a digital investment manager, such as Scalable Capital. We have done all the research on your behalf and would identify the best combination for you and your financial requirements. We would then manage your portfolio, regularly reviewing the combination of ETFs, for as long as you are our client.

Image: Jeremy Bishop/Unsplash.com

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Adam French
CO-FOUNDER & DIRECTOR
Adam spent the last 8 years working in London in the financial services industry. As Executive Director of Commodities Trading at Goldman Sachs, he was responsible for the Commodities Structured Products franchise. Prior to this, he worked in Derivatives Trading where he was responsible for electronic trading for private clients in fixed income, currencies and commodities products. Adam studied Business Mathematics and Statistics at the London School of Economics.