A market driven by ‘speculators’

John Bogle, the man credited with creating the first index tracker fund, is a respected figure in the investment community. So much so that his fans, known as Bogleheads, turn up to a conference each year in the hope of hearing him speak.

At last year’s event in October, Mr Bogle, the founder and former chief executive of Vanguard, the second-largest fund house in the world by assets under management, launched an attack on exchange traded funds that raised eyebrows at ETF providers worldwide.

ETFs, Mr Bogle warned, “have become the new way to speculate”. This is happening because ETFs can be bought and sold at any time unlike traditional mutual funds — even those that are index trackers — which typically only offer daily or even weekly liquidity.

For a long-term investor like Mr Bogle, this short-term trading behaviour is risky. “[Mr Bogle] believes an index fund is an investment to buy and hold for an investment lifetime, not one to trade at the speed of light,” says a colleague of the 86-year-old investor.

Research backs up Mr Bogle’s view, at least when it comes to small investors. A study by Goethe University, Frankfurt, found that most small investors in ETFs substantially underperformed the market, typically because they bought and sold ETFs too rapidly and at the wrong time.

“Adopting a buy-and-hold strategy is more important than selecting better ETFs for individual investors,” the study’s authors wrote.

But figures indicate that short-term investments in ETFs are common. The largest ETF in the world, the SPDR S&P 500, better known as SPY, experienced trading turnover of more than 200 per cent in the first two weeks of this year. In the US, ETFs often account for 30 per cent of daily trading volumes.

Peter Sleep, senior portfolio manager at 7IM, a UK wealth manager, says: “People do use ETFs for speculative reasons.” Some have got burnt by doing so and certain ETFs, such as commodity products, encourage speculation more than others, he adds.

In fact, a whole host of ETFs exists whose main function is to allow investors to take short-term positions. These short and leveraged ETFs — which use derivatives to deliver returns that are a multiple of the index they track — enable investors to trade tactically, says Townsend Lansing, executive director, head of exchange traded commodities at ETF Securities. “The investment strategies around short and leveraged ETFs are short-term trading.”

Concerns have been raised about leveraged ETFs, namely that an investor who remains invested in these products for more than a day could find themselves with larger-than-expected losses.

Ben Seager-Scott, director of investment strategy at Tilney Bestinvest, a UK-based wealth manager, says these products come with more risks. “Leveraged and inverse ETFs are generally not a good idea for long-term investment, but can be used to express short-term views,” he adds.

However, the use of ETFs to speculate is not necessarily bad, says Hector McNeil, co-chief executive at WisdomTree Europe.

“There is a whole host of reasons why people trade on a market — there are opportunities to make money whether you are a short-term or a long-term trader. That is really the choice and the action of the individual investor,” he says.

Mr Lansing says ETFs allow investors to express their market views.

“I don’t think ETFs change investment behaviour. If someone wants to buy an ETF to buy and hold it’s a good tool for that. If someone buys it for a tactical trade, it’s a good tool for that as well. ETFs are just providing a solution for how investors want to trade.”

Norm Champ, former director of the investment management division at the Securities and Exchange Commission, the US watchdog, and a lecturer at Harvard, agrees.

“Personally, I am a buy and hold guy, but I don’t understand imposing that view on other investors. If people want to use ETFs to trade daily, they should be able to use them that way.”

Others say the focus on the large daily trading volumes in ETFs misses an important point.

Although ETFs have traditionally been substitutes for mutual funds, they are widely used as a lower-cost solution to instruments such as derivatives when investors want to take a long or short position in their portfolio.

“Much of the volume in ETFs is from large institutions looking to hedge or neutralise their positions,” says Lee Kranefuss, executive chairman of Source, the $17.6bn ETF provider.

“Hedging is generally good for investors — it’s a way of lowering risk,” adds Mr Champ.

There have also been concerns that short-term ETF traders try to capitalise on potential weak spots in ETFs, which happened last summer as dozens of the products traded at sharp discounts to their holdings for a short period. The argument is that such behaviour could hit the price of underlying stocks dramatically.

Industry figures, however, played down any suggestions the short-term trading of ETFs is affecting the marketplace.

Sean Tuffy, head of regulatory intelligence at Brown Brothers Harriman, the US bank, says ETFs are being used in the way they were envisaged.

“ETFs were designed to be traded throughout the day, which is what’s happening. Overall I think it’s hard to get too upset that an investment product is being used for investment purposes,” he says.

Mr Tuffy adds: “I’m always a bit mystified by this use of the word speculation as a code for nefarious activity. In reality, all investment is a form of speculation.”

Mr Bogle, however, looks unlikely to change his stance. He has never been an advocate of ETFs, even rejecting the idea of ETFs when he was running Vanguard, although the fund house has since embraced the products. “Too few investors fully understand the appropriate uses of ETFs,” he says. “The ETF market is driven by speculators.”