Over recent years, investors woke up to the many advantages that ETFs offer. Firstly, as ETFs replicate a specific index, they provide immediate diversification benefits with little need for regular rebalancing by the investor. Secondly, they allow implementing market views without taking the specific risk associated with single stock investments. Thirdly, their passive management style achieves much lower operational costs, thus allowing for lower fees than traditional mutual funds. And finally, major ETFs can generally be easily traded on exchanges as they tend to have narrow bid-ask spreads.
These facts make them interesting not only for long-term investors, but also for investors who want to implement sector rotation strategies, hedging parts of their portfolio (eg with inverse ETFs) or even for short-term trading.
So, are ETFs the philosopher’s stone for investing? Stellar successes always call for critical review. Are ETFs better than mutual funds and are there systemic and counterparty risks hidden in them that are likely to lead to a major disappointment for investors?
The first question can be drilled down to: is active management dead? Our belief is that both ETFs and mutual funds fit very well into a holistic investment strategy.
Fees certainly are an important point when investing as they can heavily dent into long-term compounded returns. Therefore, if investors pay a fee, they should get alpha in return. In many efficient markets, such as US large caps, however, it is unlikely that an active manager can consistently outperform a low-cost ETF solution. Hence the case for ETFs is much stronger than the case for mutual funds in these markets.
In less efficient markets where manager skills have more potential to produce alpha, the additional fees for active management can well be justified, and a mutual fund with strong track record in generating alpha is likely to be the better choice than an ETF.
In our view, ETFs are clearly part of a holistic investment approach. A clear process has to define market segments which should be implemented with ETFs, and in which case mutual funds with active management should be preferred.
The second set of questions points more to the structure of the ETF. While the first generation of ETFs (so-called physical ETFs) is holding the stocks of the index it tracks, later generation ETFs sometimes deviate from this strategy and hold a collateral portfolio of assets that is potentially completely different from the index it intends to track. A total return swap then achieves the tracking of the index (so-called synthetic ETFs).
Under normal circumstances, the latter type of fund exhibits a relatively small tracking error. Under stress scenarios, however, this type of ETF indeed could entail some adverse behavior such as counterparty risk and liquidity issues. Conducting profound analysis of stress scenarios is therefore important before investing in ETFs.
The success of ETFs is certainly reflective of the advantages of this investment vehicle. It allows for an easy implementation of tactical and strategic views by different type of investors (ranging from retail to ultra high net worth and institutionals) at low costs. The fact that some new risks can arise from new ETF structures makes a proper due diligence and advisory process necessary.
Nevertheless, with the proper processes and checks in place, ETFs can add value for every investor if integrated in a holistic investment process.
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Terry Smith, Chief Executive of Fundsmith
When I first started looking at the problems of ETFs and discussed them with people in the investment industry, they said “they’re just index funds”.
If only they were, then there wouldn’t be a problem. In most circumstances I think investors would be better off investing in an index fund. They are low cost and most active managers underperform them. Why should you pay higher fees for worse performance?
But many ETFs are not index funds. An index fund owns the constituent securities in an index in the same weighting as the index. Some ETFs do this, but some do not own the index constituents at all. They are “synthetic”. They own derivative instruments or swaps in which a counterparty agrees to match the movements of the securities or commodities the ETF is trying to track. The credit crisis should have taught investors that there is no such thing as an undoubted counterparty, so who knows if a synthetic ETF will deliver the performance of the securities it is alleged to track in periods of financial stress?
ETF proponents claim that this problem of counterparty risk is negated by the fact that synthetic ETFs obtain collateral which they hold to ensure that if the counterparty providing the swaps on which they rely fails, they will have the wherewithal to ensure that the ETF investors will be able to realise the value they should have obtained from the swaps. But here’s the rub: the collateral can be held in instruments which bear no relation to the ETF. So your FTSE 100 synthetic ETF may hold collateral in Japanese yen bonds. When the moment comes to realise these because the swap counterparties have failed, who knows what their value will be?
