Pluses and pitfalls in the ETF revolution

Exchange traded funds are the phenomenon of the moment. Money is pouring in and ETFs are proliferating. They have transformed how many savers invest their money and the way investment advisers and brokers do business. They have also made a lot of money for stock exchanges, index providers and investment banks — far beyond the sums they generate for the companies whose names appear on the ETFs investors buy.

The important questions are why they have become so important and whether you should be excited about them.

Raw numbers demonstrate the power of ETFs. According to the latest count kept by ETFGI, the ETF research group, there are 5,632 ETFs and other exchange traded products in circulation around the world, from 245 providers. They are listed on 63 different exchanges in 51 countries. They have almost $3tn in assets and seem likely to pass that milestone during the first half of 2015. There were new flows of $50.7bn into the sector this February — the second-largest monthly flow on record and a sign that enthusiasm is not waning.

The first ETF was launched just 25 years ago, but the funds only became widely available in the years immediately after the dotcom crash in 2000. They have been revolutionary, but how? Like index funds, they are (almost all) passive — and passive investing has its own advantages. The fees of ETFs are light compared with active funds, although you need a brokerage account to buy one, which carries its own expenses. In the US — less so in other jurisdictions — ETFs also have tax advantages.

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Unlike mutual funds, by being quoted on the stock market ETFs have a price that changes throughout the day. This means ETFs can be, and are, used for active trading. Market makers, with the power to issue new shares if necessary, undertake to ensure the ETF shares trade in line with the index they are tracking throughout the day. As they know that shares can ultimately be created to bring them in line with the index, this is a safe arbitrage, and offers them the chance to make money.

Further, unlike index mutual funds, ETFs have proliferated. They are relatively cheap to set up and can be wound up if they fail to find a market. This means they have been used to track ever more specialised indices — including ones that index providers have been asked to create solely for the purposes of offering an ETF.

As they have grown, they have acquired another advantage, which is to offer a liquid way to invest in an underlying security that is illiquid. Some make a distinction between ETFs — which have an underlying portfolio of stocks in the index they are tracking — and exchange traded products (ETPs) or notes (ETNs), which merely track a note written by a counterparty — generally a large bank — that promises to move in line with an underlying security.

For example, this is how ETFs have been offered that match various commodity indices. Rather than bearing the expense of holding commodities in warehouses, the ETF merely holds a note written by a bank, which in turn will generally use futures contracts to ensure it can keep its promise to track the index. The backers of ETFs say, with some reason, that this means ETFs have opened up fresh asset classes to liquid investors.

Put all these facets together, and the great gift of ETFs is to democratise asset allocation. Academic research suggests it is the choice between different big asset classes, rather than attempts to pick the best-performing companies in particular sectors, that contributes most to returns. Using ETFs makes it easy and relatively cheap to shift between assets, and even to do so several times a day.

Understandably this makes ETFs a favourite toy of the hedge fund industry. They have also offered investment advisers a plausible new role. Rather than the rather bogus business of selecting the latest top-performing fund manager for clients, advisers can now use ETFs to manage a full client portfolio, and shift the asset allocation according to changes in circumstances, whether those be of the client’s own family finances or the world economy. Rather than charging commissions or “sales loads”, as is typical for mutual funds, ETFs can offer a straightforward investment management fee. This is preferable, as it better aligns the interests of adviser and client.

Thus ETFs have indeed revolutionised the industry. But they have also raised a number of issues.

The proliferation of ETFs has created confusion. Many funds overlap, slightly or greatly, and the deepening complexity of the indices they follow makes it harder to use ETFs for straightforward asset allocation.

It is also questionable whether ETFs are really that cheap. Many different players make money out of them. For those who do not already have a broker’s account, they are not noticeably cheaper than the largest index mutual funds.

The move into illiquid securities is also problematic. Liquidity mismatches are the classic fuel for financial crises. In other words, when somebody faces a demand to pay over money instantly, but only has illiquid assets that cannot be sold quickly, trouble begins. That is the kind of trouble some ETF providers are courting. In areas such as emerging market corporate debt, where selling in a hurry can be problematic, ETFs have taken a large share of the market.

The underwriting system has worked well so far to avoid ETFs trading at big discounts to their underlying net asset value. But the history of the sector has played out against steady, strong inflows. Exchange traded funds are yet to be tested in a crisis in which investors yank their money out and keep asking for it.

Further, as ETFs grow more esoteric, so their tracking error grows. Tracking more illiquid markets where there is a limited number of buyers and sellers makes it harder to match the market. While ETFs that track big developed market indices such as the S&P 500 can replicate their benchmark almost perfectly, this becomes harder to do in the case of esoteric assets, or in emerging markets.

For exchange traded products, there is an issue in the extra layer of risk that comes from holding an underwritten note. You are not merely taking the risk that, for example, the oil price will fall — you are also taking the risk that the bank underwriting the note could default. Generally this is a small risk but, as everyone learned after the Lehman Brothers bankruptcy in 2008, sometimes the unthinkable happens.

Finally, that ability to trade throughout the day might be useful for hedge funds, but it might also be a fateful temptation for private investors. Any attempt to try to trade moves between markets on a minute-by-minute basis is foolhardy for such individuals, and it is a shame that ETFs might encourage it.

Nobody should ignore ETFs — their usefulness is evident — but they do have their downside, and they have yet to be tested in a crisis.