Has the good fortune for ETFs run its course?

While private investors have fallen in love with them, critics argue their dominance could bring down the stock market

Illustration by Alvaro Sanmarti
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Investors all over the world have fallen in love with exchange-traded funds (ETFs) as a flexible, low-cost way of investing in the stock market.

ETFs have conquered all since the S&P 500 Depository Receipt fund tracking that the US market was released without fanfare in 1993.

They are particularly attractive to expatriates in the UAE as they put them in charge of their own investments and offer a vastly superior alternative to notoriously expensive insurance-based plans.

There is just one minor concern. Some experts claim that ETFs could become so dominant that they ultimately kill the stock market and destroy global capitalism. How worried should we be?

Success breeds success

ETFs are a runaway success story. In April last year, the amount invested in the sector topped $4 trillion, a trillion or so more than is invested in hedge funds. By November 17 that figure had jumped to $5.29tn, according to consultancy firm ETFGI.

Success breeds success, and momentum is gathering. Between January 1 and November 30 last year, an incredible $600 billion of investor money flowed into ETFs, almost double the $326bn net inflows seen over the same period in 2016.

Investors can now choose from 7,019 ETFs or exchange-traded products (ETPs) from 331 providers, with 70 per cent offered by just three main firms, BlackRock's iShares, Vanguard and State Street. ETFs seemed destined for world domination.


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Exchange-traded freedom

Some claim the market could hit $10tn as soon as 2020, as new fiduciary rules force US financial advisers to favour low-charging investment funds.

There is no doubt that ETFs offer massive benefits to private investors. They are highly “liquid” because you can buy and sell them easily, in the same way you trade stocks and shares, with minimal dealing costs. They also have tiny ongoing charges ranging from 0.07 to 0.50 per cent a year, against up to 1.75 per cent on some active funds, which mean charges eat up far less of your money over the years.

ETFs have also liberated expats from restrictive insurance-based savings plans, which are sold with rip-off levels of commission, crippling annual fees and punishing 25-year lock-in periods.

By contrast, you can buy and sell your ETFs online whenever you like, with a click of your mouse and without penalty.

ETFs are “passive” index tracking funds which means you do not need to worry about fund manager performance, but simply follow your chosen market up and down.

A DIY investor could create a low-cost portfolio by parking their money in a massive global tracker such as Vanguard FTSE All-World ETF, which invests in around 3,000 companies worldwide for 0.25 per cent a year, and pretty much forget about it. However, critics are sounding alarm bells.

Cause for alarm?

One concern is that passive funds are pouring global money into the same big name blue-chip stocks such as Amazon, Apple, Google and Facebook. The danger is that their share prices could become detached from company performance, stifling competition and making life much harder for new entrants.

Another concern is that the rush of money will inflate dangerous bubbles in the good times and accelerate the crash in a downturn, as investors rush out just as quickly. There will also be too few active investors able to stabilise the market by hunting down buying opportunities.

In September, Mohamed El Erian, chief economic adviser at German insurer Allianz, publicly warned that the proliferation of cheap ETFs has created a “huge risk of contagion”.

He said these instruments were "over-promoting liquidity in asset classes" and were more likely to cause the next global financial crisis than the banks.

Deutsche Bank strategist Jim Reid is also alarmed, warning that the “extraordinary" amounts are going into ETFs yet the sector has never been tested in a market correction, when they could dangerously multiply its effects. “The real test could be when we see the next downturn and these products are faced with heavy redemptions,” he says.

Paul Singer, head of hedge fund manager the Elliott Management Corporation, fears that passive funds have “destructive” potential. "What may have been a clever idea in its infancy has grown into a blob which is destructive to the growth-creating prospects of free-market capitalism.”

He says the decline of active management is hurting the free market. “Passive investing is in danger of devouring capitalism.”

So how scared should we be?


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Consumer champion

Oliver Smith, portfolio manager at online trading platform IG Index with offices in Dubai, says these claims are “hyperbolic” and ETFs are a major force for the good, especially for private investors. “They have facilitated a huge transfer of wealth from fund managers and brokers to the consumer. Who would have thought, 10 years ago, investors could buy a fund investing in the S&P 500 for total annual charges of just 0.07 per cent, and a dealing charge of just a few dollars?”

Mr Smith says ETFs are simply another investment vehicle, one that offers investors a cheap and efficient way to get market exposure.

The sector survived the financial crisis in good shape, and investors who wanted to sell were able to do so. “The same cannot be said for many hedge funds,” he adds.

So do ETFs manipulate share prices? Mr Smith’s answer is not yet. “Active managers continue to set share prices, index funds continue to be passive players. There is space in the market for both of them. Fund managers should always be able to scour the market for investment bargains, but will have to get used to playing a smaller role.”

Passive victory

Sebastien Aguilar, co-founder of UAE-based non-profit community Common Sense Personal Finance and Investing, suspects many of the criticisms of ETFs come from vested interests, including financial advisers who feel threatened by the growth in DIY investing. "Critics clearly couldn't find any other argument against ETFs, aside from bringing up an unlikely doom and gloom scenario," he says.

He admits it would be a problem if every investor adopted passive strategies, as this would leave nobody to value companies or monitor how they operate. “However, active investing will always exist, as there will always be people hoping to outperform the market. I believe we will reach an equilibrium where both active and passive investing works well together.”

Most private investors should invest in passive funds, Mr Aguilar argues, because active fund managers struggle to beat the market, yet charge high fees for giving it a go, which eat into your returns. “ETFs are far more efficient and accessible. All the independent research leads to the same conclusion, that active investing typically underperforms passive because of the higher fees, and this becomes more significant over longer periods.”

Even successful fund managers have trouble repeating their triumphs, suggesting that any success is largely down to luck, Mr Aguilar adds.

He backs his point of view by citing the Spiva scorecard, which rates the S&P 500 Dow Jones and shows that between 80 per cent and 99.43 per cent of funds underperform their benchmark over 15 years.

Similarly, the latest FundWatch survey from BMO Global Asset Management shows that “an overwhelming proportion of funds” fail to deliver above average returns consistently over a three-year period.

Only 109 of 1,129 funds across 12 sectors delivered above median returns in each of the last three 12 month periods and Kelly Prior, investment manager in BMO’s multi-manager team, says fund performance continues to deteriorate. “More than nine in 10 failed to consistently generate above average returns.”

Laith Khalaf, senior analyst at Hargreaves Lansdown, thinks it highly unlikely ETFs could trigger the next market crash. “ETFs might bear the brunt of the next stampede from global equity markets because of their popularity and liquidity, but the exodus would have happened anyway. Markets move in cycles and money flows in and out, and it uses whatever vehicles are handy to get where it wants to go.”

He accepts the glut of passive money could ramp up the share prices of the biggest companies, but says criticisms have been overdone. "Active funds would probably have bought most of those companies anyway, to reflect the market,” Mr Khalaf adds.

Active defeat

Sam Instone, chief executive of AES International, gives short shrift to ETF critics, suggesting they have vested interests in defending active management. “Many of them will be self-serving, overpaid, underperforming active fund managers, looking to peddle their outdated and often toxic wares.”

He pours scorn on arguments that passive fund investors will bail out in the event of a stock market crash, pointing to the behaviour of investors in Vanguard’s fund range during the financial crisis. “The majority sat it out rather than selling up and profited handsomely from the stock market rebound. Speculators and those who focus on the short term are the ones who typically panic and flee when markets crash, not those who choose a low-cost, passive approach to long-term investing.”

Mr Instone also rejects claims that ETFs could squeeze the life out of capitalism as investors passively sit in company stocks. “Competition, innovation, pricing knowledge and a drive for quality improvements will always have a role. Anything else is a snake oil myth created by those whose own economic interests aren’t aligned with passive investment," he says.

He adds that ETFs attract significant investment for the simple reason that they are an easy and cheap way to invest. “They are consistently far more successful than the majority of crystal ball gazing active managers. These managers do not like it, and will continue to predict doom and gloom to deflect investors away from ETFs.”

ETFs have a small number of critics but they are outnumbered by a large and growing band of supporters. So far, their faith has been amply rewarded.

ETFs look to have a long and lucrative future ahead of them.