Is the ETF revolution coming to an end?

Private investors have embraced low-cost index funds but some are beginning to question if the sector has grown too fast

You can have too much of a good thing, and some investors are beginning to wonder whether that is now the case with exchange-traded funds (ETFs).

There’s no question that ETFs have been very good for private investors, allowing them to compete with the professionals by giving them access to a vast range of funds that track almost every imaginable market or asset class at minimal cost.

ETFs have liberated private investors from rip-off fund management fees, which swallowed a vast chunk of their growth and income in both rising and falling markets, all the while enriching the managers.

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

By the end of August, global investors had pumped another $834.2 billion into ETFs, racing past last year’s total of $762.8bn with four months of the year still to go.

Massive inflows and stimulus-fuelled stock markets have lifted the total invested in ETFs to an incredible $9.7 trillion, data provider ETFGI said. That is more than double the amount at the end of 2018 and more than triple the $3tn total hit in May 2015.

Now, however, some are beginning to question whether the ETF revolution has gone too far, too fast. ETFs have thrived during the lengthy bull markets we have enjoyed since the 2008-09 financial crisis as they have passively tracked asset prices higher and higher.

Yet, at the same time, everybody knows this is a false market, buoyed by years of near-zero interest rates and fiscal and monetary stimulus.

What happens when this finally dries up? Holding a handful of trackers may be great fun when share prices are shooting up, but the party could come to an abrupt end when they are passively tracing the market downwards.

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To judge whether ETFs are out of control, one must consider if market sentiment is out of control
Damien Maltwood, executive director, Quilter Cheviot’s Jersey office

Damien Maltwood, executive director at Quilter Cheviot’s Jersey office, applauds how ETFs have given private investors access to equity, bond, commodity and other asset markets at minimal cost, but says all they do is echo market sentiment.

“To judge whether ETFs are out of control, one must consider if market sentiment is out of control,” he says.

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

At the same time, it is rational – investors are confident that central bankers and politicians will come to the rescue if any crash turns serious. They’ve been doing it for more than two decades, after all.

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

They direct money into companies that have done well in the recent past, Mr Maltwood says. “The more money that flows into ETFs, the more expensive these stocks become. So, investors may have their biggest exposure to expensive companies that are most susceptible to a correction in price.”

As an example, the world’s largest ETF is the SPDR S&P 500 ETF Trust from State Street, which currently has a thumping $402bn under management. When investors buy that fund, yet more money goes into the big guns that make up the S&P 500, rather than those sitting outside.

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

He acknowledges that there is a problem with this theory. The sheer weight of money going into ETFs can support today’s overpriced valuations for years.

“This may happen even if the fundamentals do not justify the high valuations, leaving active managers trailing the index,’ Mr Maltwood says.

During that time, the active managers could lose investor support while price bubbles last longer than rational investors would expect, he adds.

One of the strongest arguments in favour of ETFs is that three quarters of active fund managers fail to beat the market each year, yet cost more.

Even those who do win one year may struggle the next, whereas trackers grind on, matching the market with only a small fee deduction. Fund managers have struggled to defend themselves against this charge, but could they come into their own in a bear market?

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

Couple getting financial consult. Getty Images

“That’s because most ETFs pick stocks purely on market cap. They do not reward superior profitability, return on equity or capital efficiency,” Mr Harvey says.

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 superior performers whose shares have been overlooked,” he says.

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

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

Tracking the market has been a winning strategy but markets could lose momentum if inflation steps in and forces the US Federal Reserve to increase interest rates, Chaddy Kirbaj, vice director of Swissquote Dubai says. “At that point, ETF performance could dip. No bullish cycle lasts forever.”

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Most ETFs pick stocks purely on market cap. They do not reward superior 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, because managers can exit certain stocks or sectors they consider vulnerable, or use more complex techniques such as hedging and derivatives to reduce risk.

By contrast, ETFs must simply continue to track their chosen index, even if it idles for years, Mr Kirbaj says. Yet history also shows that many fund managers struggle to add value in falling markets. Their funds can sink just as fast as trackers. Sometimes faster.

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

“ETFs allow investors to gain exposure to broad markets and more focused segments, at much lower cost. It’s not surprising that investors have voted with their feet,” he says.

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

Actively managed funds have an inbuilt disadvantage because higher charges are a drag on returns, one that managers struggle to overcome because consistently beating the market is so difficult. “This will continue to make the case for low-cost index investing so powerful,” Mr Plagge says.

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

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

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

“They make up less than 10 per cent of the $100tn global asset managers invest for their clients,” Mr Mellor says.

The risks of buying an ETF is not very different to other investment vehicles, he says. “The biggest test for the ETF structure came in the Covid sell-off in March last year. It is fair to say that they passed the test with ease.”

Both active and passive strategies have their place, Mr Mellor says. “An active manager would generally be expected to benefit from uncorrelated markets, where securities don’t all move in unison and it’s therefore possible to capitalise on differences.”

Active fund managers have been alerting investors to the risks in ETFs for years, but so far they have been on the losing side of the argument.

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

The ETF revolution has been hugely welcome, and long may it last. A sprinkling of active fund management still has its place, though. We may find how big that place is when this bull market finally runs out of steam.

Updated: September 20th 2021, 5:00 AM
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