The Rise of the ETF

24 January 2017  |  Simon Miller
The Rise of the ETF
We firmly believe in broad diversification and combining that with effective risk management.
Using ETFs best achieves the global diversification and dynamic trading that we consider to be so important. Here we address some of the unfair criticisms of ETFs and passive investing.

The popularity of ETFs has soared in recent years and as with most new products changing an industry they have met criticism from the incumbents. A common feature of ETFs is to follow a passive investment strategy, with one recent headline describing that as ‘worse than marxism’. We disagree with the critics and use ETFs across all our portfolios. We believe that when used correctly, they allow investors low-cost access to fully diversified and highly liquid portfolios. Their use has proven successful for us, so we wanted to put right some of the common criticisms.

Put my estate in index funds

– Warren Buffet to his heirs.

What is an ETF?

Exchange-Traded Funds (ETFs) have evolved over the years but they began as a passive instrument, tracking the performance of a market index. Much like a stock, they trade on an exchange which allows transparency and liquidity. They don’t require the high fees demanded by active managers, giving investors cheap exposure to all the major asset classes. In one single transaction an investor can gain exposure to a whole region or asset class; at Scalable Capital one of the ETFs we use is an Emerging Markets ETF which contains over 1,900 securities.

Since their launch, the product has evolved making active, leveraged and Smart Beta ETFs now available. However, the passive variety forms the overwhelming majority, especially when looking at the assets held under management. We aim to select the best ETFs for our client portfolios, which includes the use of the passive type only. We use these passive instruments as the building blocks of our portfolios to give clients access to globally diversified portfolios in a very cost-effective way.

The Rise of ETFs And Their Common Criticisms

The first ETF was launched in Canada in 1993 and since then their popularity has steadily increased. In 2002 there were 102 funds across the world, which had risen to almost 1,000 by the end of 2009 and reached 4,396 by 2015. There is now thought to be around $3,300 billion invested in ETFs globally, making the ETF market bigger than the hedge fund industry.

As mentioned earlier, the majority of ETFs remain passive, however, some claim that this prevents the efficient allocation of capital. As the argument goes, actively managed instruments move money into good companies, pushing stock prices up and enabling them to raise money and expand. Underperforming companies see their stock price fall as their capital is allocated to better companies. Should all investors use passive ETFs to track indices, there wouldn’t be anyone ‘reacting’ to relevant news. Passive funds supposedly support underperforming companies whereas active instruments allocate capital more efficiently.

Amounts Invested in ETFs Constantly Growing

Global ETF growth from 2005-2016

Global ETF growth from 2005-2016
Source: ETFGI Global ETF Growth http://etfgi.com/index/home

However, these critics miss two important points:

  • Secondary markets, where passive investing is more common, are less about fundraising and price discovery. When companies are private and actually raising funds, active management still dominates.
  • In the 2015 UK Asset Management Survey passive investing only made up 20% of the total market. Even if passive investors made up over 50% of the total, there is little evidence to suggest that that would prevent active managers from maintaining an efficient market.

In other words, even if you believe that passive investing could prevent an efficient market, we are still a long way away from passive investing being a large enough market share for those fears to be realised.

‘Herding’ and the idea that investors no longer ‘react’ to news is often associated with passive instruments. However, consider the narrow breadth of equity research reports that active fund managers tend to read. It quickly becomes clear that active managers all read and react to the same information in the same way, ‘herding’ themselves. The data itself tends to be skewed towards ‘buy’ recommendations as they bring the most benefit to the banks that publish the research. It quickly becomes apparent that investment decisions made by active managers can be more herd-like than those made by retail investors using passive ETFs.

In a recent article for the Financial Times, Patrick Jenkins used an obscure ETF to argue against all ETFs in general. He was particularly concerned with the Goldman’s Global X Guru Index ETF, which is pegged to the 50 most popular equity holdings among hedge funds. The theory is that returns will be improved by tracking a hedge fund’s stock picks rather than a standard index, such as the S&P. In practice, the Global X ETF has returned 1.6% over the past three years whereas the S&P delivered more than 30%. Jenkins blames this on market timing – the ETF falls slightly out of time with the hedge fund stock selections due to regulatory disclosure delays. He tarnishes ETFs in general with this niche product. However, his argument seems simplistic. After all, bad individual companies exist but that doesn’t stop you from investing in companies in general.

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In Conclusion

Media reports of ‘no longer knowing what price to pay for a stock’ are some distance from the truth; we are still a long way from ETFs dominating the world. Some underperforming active funds will be driven out of the market in favour of their cheaper, index-tracking competitors, but their absence is the stock market’s own version of natural selection. The market should find that balance itself.

We firmly believe in ETFs. They allow broad diversification, low costs, high liquidity and high transparency. We carefully pick our passive ETFs from the universe of 1,500 based on thorough selection criteria. The weight of the ETFs chosen varies according to investment strategy and appetite for risk. Don’t believe the scaremongering, ETFs deliver the best solution for our clients.

Risk Warning – With investment comes risk. The value of your investment can go down as well as up and you may get back less than you invest. Past performance or future projections are not indicative of future performance. We do not provide any investment, legal and/or tax advice. If this website contains information regarding capital markets, financial instruments and/or other topics relevant for investments of assets, the exclusive purpose of this information is to give general guidance on investment management services provided by members of our group. Please note our Risk Warning and the Website Terms.

 

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Simon Miller
UK CEO & UK CO-FOUNDER
Formerly a derivatives trader at Barclays Capital, Simon merges capital markets knowledge and business development skills with an academic background in Economics, Business and Mathematics.