Is the ETF revolution coming to an end?


You can have too many good things, and some investors are starting to wonder if that’s the case now with exchange-traded funds (ETFs).

There is no doubt that ETFs have been very useful for private investors, allowing them to compete with professionals by giving them access to a wide range of funds that follow almost any market or asset class imaginable at minimal cost. .

ETFs have freed private investors from fraudulent fund management fees, which have swallowed up much of their growth and income in both bullish and bearish markets, while also making managers rich.

Once ordinary investors saw the benefits, they flocked to buy them – and continue to do so today.

As of the end of August, global investors had pumped an additional $ 834.2 billion into ETFs, surpassing last year’s total of $ 762.8 billion with still four months of the year.

The massive inflows and stock markets fueled by the stimulus have brought the total invested in ETFs to an astounding $ 9.7 trillion, data provider ETFGI said. This is more than double the amount at the end of 2018 and more than triple the total of $ 3 billion raised in May 2015.

Now, however, some are starting to wonder if the ETF revolution has gone too far, too fast. ETFs have thrived during the long bull markets we have seen since the 2008-09 financial crisis as they passively tracked asset prices higher and higher.

Yet at the same time, everyone knows it is a fake market, driven by years of near zero interest rates and fiscal and monetary stimulus.

What happens when it finally dries up? Holding a handful of trackers can be a lot of fun when stock prices are soaring, but the party might end abruptly when they passively follow the market down.

To judge whether ETFs are out of control, consider whether market sentiment is out of control

Damien Maltwood, Executive Director, Quilter Cheviot Jersey Office

Damien Maltwood, Executive Director of Quilter Cheviot’s Jersey office, praises the way ETFs have given private investors access to equity, bond, commodity and other asset markets at minimal cost, but claims that all they do is echo the sentiment of the market.

“To judge whether ETFs are out of control, you have to consider whether market sentiment is out of control,” he says.

Given that global stock markets are repeatedly breaking records, even though the economy has been ravaged by an unprecedented pandemic that is not even over, market sentiment is certainly, well, questionable.

At the same time, it makes sense – investors have confidence that central bankers and politicians will come to the rescue if a crash becomes serious. They have been doing this for over two decades, after all.

Another concern is that ETFs may have contributed to the insane growth of the market by throwing investor funds at the big winners in the market, especially the big US tech companies.

They direct money to companies that have done well in the recent past, said Maltwood. “The more money that flows into ETFs, the more expensive these stocks become. Thus, investors can have their greatest exposure to expensive companies which are most susceptible to a price correction. “

As an example, the largest ETF in the world is State Street’s SPDR S&P 500 ETF Trust, which currently manages $ 402 billion. When investors buy this fund, even more money goes into the big guns that make up the S&P 500, rather than the ones sitting outside.

In contrast, Maltwood says a good active manager will reduce the holdings of expensive companies and recycle the money into cheaper stocks with greater growth potential.

He recognizes that there is a problem with this theory. The sheer weight of money invested in ETFs can support today’s overvalued valuations for years to come.

“This can happen even if the fundamentals do not justify the high valuations, leaving active managers behind the index,” said Mr. Maltwood.

Meanwhile, active managers could lose investor support as price bubbles last longer than rational investors might expect, he adds.

One of the strongest arguments in favor of ETFs is that three quarters of active fund managers fail to beat the market every year, but cost more.

Even those who win one year may struggle the following year, as the trackers continue, matching the market with only a small fee deduction. Fund managers struggled to defend themselves against this accusation, but could they prevail in a bear market?

The more money that goes into index products, the less efficient the market becomes, says Alex Harvey, senior portfolio manager and investment strategist at MGIM.

“This is because most ETFs choose stocks based solely on their market capitalization. They don’t reward superior profitability, return on equity or capital efficiency, ”says Harvey.

This blind tracking of big blue chips gives active fund managers the opportunity to add value. “They can look beyond the index titans to identify top players whose stocks have been overlooked,” he says.

When the market turns, active managers may find it easier to justify their higher fees, says Harvey. “It may be worth paying a few more basis points for a higher rise or a less painful fall. Or maybe both.

The case for using ETFs is stronger with bonds, where outperformance is harder to achieve, while lower fees mean you keep more of your returns, he says.

Following the market has been a winning strategy, but markets could lose momentum if inflation escalates and forces the US Federal Reserve to raise interest rates, said Chaddy Kirbaj, vice-director of Swissquote Dubai. “At this point, the performance of ETFs could drop. No bull cycle lasts forever.

Most ETFs select stocks purely on the basis of market capitalization. They do not reward higher profitability, return on equity or capital efficiency

Alex Harvey, Senior Portfolio Manager and Investment Strategist, MGIM

This is where active management can come into its own, as managers can exit certain securities or sectors they deem vulnerable, or use more complex techniques such as hedging and derivatives to reduce risk.

In contrast, ETFs should simply continue to track their chosen index, even if it has been inactive for years, Kirbaj said. Yet history also shows that many fund managers struggle to add value in declining markets. Their funds can sink as fast as trackers. Sometimes faster.

Jan-Carl Plagge, senior investment strategist at tracker specialist Vanguard, says indexing will continue to bring huge benefits to investors.

“ETFs allow investors to gain exposure to large markets and more targeted segments, at a much lower cost. It’s no surprise that investors voted with their feet, ”he said.

The rationale for index investing is compelling because mathematically, not all investors can outperform the market, Mr. Plagge said. “Logic dictates that for every position that outperforms, there has to be another position that underperforms.”

Actively managed funds have an inherent drawback as higher fees are a drag on returns, an issue managers struggle to overcome because it’s so hard to consistently beat the market. “This will continue to make the case for low cost index investing,” Plagge said.

Active management can add value, but for most investors, the place to start should be a diversified portfolio of index funds, he says.

“Beyond that, it’s a question of individual risk tolerance. Are you willing to take the risk of potential relative underperformance for additional return? “

Chris Mellor, head of EMEA ETF equity and commodity product management at asset manager Invesco, also rejects the idea that the ETF industry is out of control.

“They represent less than 10% of the $ 100 billion invested by global asset managers for their clients,” Mellor said.

The risks of buying an ETF are not much different from other investment vehicles, he says. “The biggest test for the ETF’s structure came with the sale of Covid in March of last year. It’s fair to say that they passed the test with ease.

Both active and passive strategies have their place, says Mellor. “An active manager should generally benefit from uncorrelated markets, where stocks don’t all move in unison and therefore it is possible to capitalize on differences. “

Active fund managers have been warning investors about ETF risks for years, but so far they have been on the losing side.

It didn’t help their cause that many of them were operating closet benchmark trackers themselves, while charging higher fees for the privilege.

The ETF revolution has been extremely well received, and is going on for a long time. However, a pinch of active fund management still has its place. We can find out how big this place is when this bull market finally runs out of steam.

Updated: September 20, 2021 5:00 a.m.


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