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Impact Investing

IPE special report May 2018

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ETFs: Part of the furniture

Amin Rajan argues that the success story of exchange traded funds is here to stay

Launched in 1976, the first ever index fund only raised $11.3m (€8.6m), 93% short of its target of $150m.  

“When the underwriters brought me the news of the failure, they suggested that we call the whole thing off and cancel the deal” writes John C. Bogle in his latest book, The Clash of the Cultures: Investment versus Speculation. “Oh, no we don’t.” retorted the founder of today’s $4.5trn index fund industry.

The first index mutual fund was referred to as ‘Bogle’s Folly’. Yet, over time, it outperformed expectations, paving the way for exchange traded funds (ETFs) in 1992. Currently, $1.6trn is invested in ETFs worldwide, growing at 40% annually.

They are cheap to run, since the majority track indices rather than attempt to outperform them. They slice and dice the indices while providing intra-day liquidity. Leveraged ETFs aim to maximise performance by borrowing to deliver a multiple of daily return. In contrast, inverse ETFs seek to give a multiple of the opposite return for an investor wishing to bet against the market. The target performance of ETFs is set daily. This is a far cry from the original aim of the indices.

The Dow Jones Industrial Average was created in the nineteenth century as a summary measure of daily market changes. Now, indices are used for judging performance or as a means of investing. They are an easy route into an asset class without having to pick individual managers or securities.  They are also seen as cash equitisation vehicles that invest excess money that would otherwise languish in a low interest rate environment.
They are used to short the market, or to hedge and trade in an opaque manner. Above all, they are seen as the perfect investment vehicle for executing risk-on/risk-off trades in this era of prolonged volatility.

Although they are 10% of the size of the mutual fund industry in the US, they account for a third of all US equity trades. “Low cost and intraday pricing are important,” says Neeraj Sahai, global head of securities and fund Services, Citi, “but the untold story is that ETFs have done an excellent job at developing actionable themes that resonate with investors.”

The flipside
No wonder, then, that forecasts envisage the ETF industry to grow six-fold to $9.5trn by 2020. Yet Bogle, for one, laments what he calls “the invasion of the ETF” for four reasons.

First, he notes that ETFs are markedly different from the traditional index funds held by buy-and-hold investors with a redemption rate of around 10% per annum. ETFs are used by short term investors with staggeringly high trading activity: annual turnover rates average 1,400%, with some as high as 10,000%. Clearly, the implied opportunism is driven by hedge funds and high-frequency traders.

Second, 96% of individual ETFs and 87% of ETF assets are highly concentrated. They cover narrow market segments such as commodities and emerging markets. “Given the astonishing array of more than 1,400 ETF options available, investors and speculators should just throw a dart to make their selection,” muses Bogle.

Third, many of the relatively solid offerings fall short of expectations in his three samples.
In Bogle’s first sample, covering narrowly focused ETFs, the difference between the time-weighted returns reported and the dollar-weighted returns actually earned by investors is a big one. Over a five-year period, the reported returns were 21.3%; the earned ones were 0.8%. The corresponding numbers for his second sample of broad based ETFs were -4.8% and -10.8%. The numbers in his third sample, covering 62 ETFs with a ten-year track-record, showed a difference of 50% between reported and earned outcomes. Translation: timing of investing is everything.

Finally, synthetic ETFs – prominent in Europe – carry counterparty risks. They do not own assets as collateral. Instead, they rely on derivatives from investment banks to deliver the return of the targeted benchmark, such that the investor faces the risk that the bank may not be able to pay up.

The future
These concerns point to potential limitations – but not on a scale to detract from the merits of ETFs. This is evident from the three scenarios for this decade, as identified in our research programme.

The first scenario envisages that ETF growth will persist, as institutional investors intensify their search for low cost solutions.  ‘Smart beta’ strategies – pursuing long term themes like cash flow, dividends, and low variance – will gain traction. This pursuit will intensify if active management struggles to deliver acceptable returns within a value-for-money fee structure.

The second envisages a few blow-ups from the headlong growth – in line with every big investment idea in the past. Thus, the index industry will go back to basics and traditional indexed funds will re-establish their ascendancy. Besides, once the current unusual risk-on/risk-off cycles subside, ETFs may lose their edge.

The third scenario argues against projecting into the future. The world of investing is cyclical and self-correcting. The new wall of money flowing into the traditional index funds as well as ETFs carries concentration and momentum risks. It is also creating a pool of underpriced assets excluded from the indices. While this might create market inefficiencies that active management could exploit, ETFs will still play a complementary role in investors’ portfolios.   

Concluding remarks
Price wars, additional questions regarding the underlying indices, and an ever-growing array of subscale products create headwinds for the ETF industry. But as long as ETF providers deliver low-cost, innovative solutions, their future remains bright.

Amin Rajan in CEO of CREATE-Research

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