The rise of ETFs as the cheaper alternative to actively managed investment funds may rightly be called a success, with some USD 3 trillion under management. The index trackers are ‘cheap, safe and transparent’. But not everyone is quite so enthusiastic.
Last year John Bogle, founder of Vanguard and inventor of the index funds, called ETFs “the greatest marketing innovation of the 21st century” and questioned the usefulness of ETFs as an investment vehicle for long-term investors.
In May, the US regulator SEC raised the alarm. Chair Mary Jo White stated that the increasing popularity of ETFs necessitates keeping a close eye on developments. That signal was taken as a warning the monitoring and regulation around ETFs is to be tightened.
The SEC announced that research has been done into what happened during the Flash Crash of 2010 and the sharply higher volatility in August 2015 in terms of the price formation of ETFs versus underlying equity markets. This report stands in sharp contrast to a recent study from asset manager Natixis, which shows that 64% of investors consider ETFs to be a ‘safer investment’.
According to Peter Ferket, Robeco’s CIO Equities, it is crucial that we don't tar all ETFs with the same brush. “You can't compare an ETF on the S&P500 with an ETF on technology stocks in China. Not every ETF succeeds in following the underlying index effectively. Some ETFs do that well, but thanks to synthetic replication, create a whole new risk – counterparty risk.” In short, ETFs might be cheap, safe and transparent, but that's not true of all products, by any stretch.
With the abolition of the distribution fee, the difference in costs between active funds and ETFs has also been reduced somewhat, especially for the more exotic products. And then there's the question as to whether investors really benefit from the cheaper index solutions. Bogle had already questioned the merits of ETFs for long-term investors, but academic research (Bhattacharya et al, 2013, “The Dark Side of ETFs”) also indicates that investors in ETFs trade more often, thus negating any cost benefits.
‘The extra flexibility that ETFs offer does not lead by definition to higher returns’
“It's undeniably a benefit that ETFs can be bought or sold at any given moment. But this tempts investors into trading even more based on their emotions. This extra flexibility does not lead by definition to higher returns”, states Ferket, with some degree of understatement. More frequent trading and buying or selling at the wrong moments – these elements cause your cost advantage to disappear like snow in summer.
And it's no accident either that the SEC is investigating the price formation of ETFs in the Flash Crash of 2010. “In principle, market liquidity is improving, as argued by BlackRock, precisely because of the growth of the ETF market. You can see this with high yield, for instance, where liquidity is greater due to the secondary market that has expanded through the trade in high-yield ETFs. But once there's a panic, the door will always be too narrow.” Yes, with ETFs you can press the sell button in the event of a crash, but it's anybody's guess what price you will get then. This could be considerably lower than for the underlying index.
‘The fact that it takes just a second to buy such a position with an ETF is a sign that something's not right under the hood’
“That extra liquidity definitely comes at a price”, suggests Ferket. “It takes just a second to buy a position of USD 10 million in both a US Equities ETF and in a US High Yield ETF. But the real underlying liquidity is a very different ball game. You can build that USD 10 million position in US largecaps in just five minutes, but to obtain such a position in high yield could take you two or three days. The fact that it takes just a second to buy such a position with an ETF is a sign that something's not right under the hood, and in times of panic that can become painfully obvious in the price formation of ETFs.”
The days when investors had a choice of 10 or 20 ETFs are long gone. There are now some 6,000 ETFs on the market, including leveraged, short variants and increasingly all sorts of smart-beta ETFs. So active and passive markets are further converging with the growth of these products. “For investors, it is becoming more and more important to find out what's under the hood. With the growth of new products and players, there's both wheat and chaff to be found among ETFs.”
“Fortunately, my concern that a major synthetic ETF would collapse appears unfounded”, says Ferket. “But the increasing supply also brings with it a greater chance of disappointing returns from some of these products. Especially with high yield, we see large disparities in the performance of ETFs as not every vendor really succeeds in following the index. Liquidity in the market is low, the costs high.” And in the event of a market crash – especially in the less liquid corners of the market (high yield, Chinese A-shares, etc.) – any decline could be worsened by trigger-happy ETF investors.
However, an ETF is still a great package for many investors, Ferket acknowledges. And that's true for Robeco, as well, as we can't rule out using ETFs on a number of Robeco equity strategies in the near future. “We offer various packages – retail and institutional funds and mandates – so why not an ETF wrapper? You could then buy an ETF on a Robeco strategy from a distributor, giving you extra liquidity at more or less the same cost.”