Is criticism of ETFs justified?

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Exchange-traded funds (ETFs) have come under intense scrutiny as their role in the financial system has grown. Is the criticism accurate or just propaganda pumped out by an active fund industry on the run?

Is criticism of ETFs justified? ETFs and index funds have many prominent supporters, including one of the world’s richest men – investing legend Warren Buffett. Moreover, investors are voting with their wallets as active equity funds experienced asset outflows of near $3 trillion over the last 10 years while passive equity funds grew by almost $2 trillion in the same period (Ref: BIS).

The word is out that investors are better served by low-cost products but the active fund industry is not giving up without a fight. The stakes are as high as their fees as the UK fund industry is one of the most lucrative in Europe according to the Financial Conduct Authority (FCA). That profitability is jeopardised by competition from cheap ETFs and index funds hence the increasing barrage of criticism aimed at passive investments as they gain in popularity. The most common objections are:
 
1.  ETFs may become weapons of financial mass destruction.
2.  ETFs jeopardise the stability of the global financial system.
3.  Too much passive investing would lead to inefficient markets.
4.  ETFs can cause capital distortions.
5.  ETFs cause flash crashes.
6.  Passive investing is worse than Marxism.
7.  ETF investors underperform.

Let’s investigate these claims and separate fact from fiction… 

 

ETFs may become weapons of financial mass destruction

The power of derivatives to inflict massive damage upon the financial system was written into history by the global financial crisis of 2008-09. Interdependent financial institutions miscalculated their exposure to risk and dealt a blow to the real economy that is still felt today. 

Back in 2011, some commentators pointed the finger at synthetic ETFs as a possible source of a future crisis triggered by derivatives. Synthetic ETFs came under suspicion because they use derivatives known as total return swaps to replicate their index. Total return swaps expose ETF investors to 'counterparty risk' – the chance that the derivative provider fails to honour their side of the contract. The theory is that extreme market shocks could bankrupt the large financial institutions (the counterparties) offering total return swaps thus placing investor capital at risk. 

Yet synthetic ETFs existed in 2008 and survived the crisis. Granted, the ETF market was smaller then but synthetic products were a larger share of the pie. Still, the doubt clouding derivative use caused providers to shift their offerings in favour of simpler, physical ETFs that do not rely on total swaps for their returns.
 
The decline of synthetic ETFs

The decline of synthetic ETFs

Learn more about synthetic ETFs and why some providers still believe they make sense.
More about synthetic ETFs
Unlike the derivatives at the heart of the 2008 crisis, ETFs are subject to strict rules that limit the damage counterparty failure could cause. European regulations dictate that the counterparty must deposit collateral worth 90% of the ETF’s Net Asset Value (NAV) with an independent custodian. If a catastrophic financial failure did take down the counterparty then the collateral would be sold to repay investors. Collateral is revalued daily and topped up when it falls short of the 90% of NAV rule. In reality, most ETF providers go further still and ensure that collateral worth 110%, or even 120%, is on hand to cover investors. Learn more about how synthetic ETFs reduce counterparty risk.

It’s also worth recognising that ETF providers take care to publish up-to-date information on their collateral precautions and methodology in a format that retail investors can easily consume. This approach stands in contrast to the Collateralized Debt Obligations (CDOs) that prompted the panic of 2008. The complexity of CDOs deceived institutional risk managers and ratings agencies alike so that the entire system sleepwalked into disaster. Whereas the transparent approach of ETF providers shows that they have nothing to hide and has enabled them to settle concerns raised by customer feedback. 

 

ETFs jeopardise the stability of the global financial system

The performance of index trackers fluctuates in line with the markets they replicate – this is what they are designed to do. But that hasn’t stopped some critics using this feature to suggest that passive investors’ mechanical price-taking is responsible for increasing volatility in the market. However, cold water has been poured on this idea by none other than the Bank for International Settlements (BIS) – the institution that fosters cooperation between the world’s major central banks. The BIS study says that active investors are the most likely to sell during times of market stress as they are most sensitive to short-term market moves. The sheer size of active fund holdings also means they have the biggest impact on the market in absolute terms. The study’s authors also note that passive investors are more likely to buy-and-hold although there is evidence to indicate that some short-term traders contribute to volatility using ETFs as active trading tools. 

 

Too much passive investing would lead to inefficient markets

What if everybody was a passive investor? This is the future dystopia often conjured by active fund managers keen to stop the passive juggernaut biting too hard into their fees. The argument is that markets could no longer accurately value assets in a world dominated by index trackers. Yet the skill of active investors is supposed to reside in their ability to exploit market inefficiencies. They profit by trading over – or undervalued assets. If passive investing did cause mispricing then active investors would step in to profit and thereby correct the inefficiency. 

In reality, the 8% growth in passive fund market share over the last decade has not enabled active investors to profit from 'dumb money' judging by the SPIVA rankings. What’s more, we’re a long way from market domination by index trackers – they still only account for 20% of the global investment fund universe measured by assets under management. 

 

ETFs can cause capital distortions

There is some evidence that major index changes can have a large impact upon small markets. For example, MSCI’s 2010 reclassification of Israel from an emerging to developed market had an outsize effect on local equity prices because emerging market fund sales were larger than developed market fund purchases. Similarly, Pakistan’s stock market was boosted by the country’s admission to the MSCI Emerging Market index in mid-2017. However, the percentage impact of such shifts on a broad market investor’s portfolio is negligible given these countries are index flyweights. Moreover, index recognition opens up long-term opportunities in these markets as improved access to capital improves liquidity, regulation, investor participation, efficiency and ultimately market depth. 

 

ETFs cause flash crashes

The S&P 500 lost over 5% of its value in a few frenzied minutes during the flash crash of August 24th 2015. The plunge caused some leveraged ETFs to lose 99% of their value in the most extreme cases. However, it’s well documented that automated trading algorithms were the root cause of the crash and stock markets have since developed a number of procedures to mitigate the problem. The main lesson here for passive investors is that leveraged ETFs are highly specialised products that are especially volatile in turbulent conditions. Only use them if you fully understand the risks involved.

 

Passive investing is worse than Marxism

Linking passive investing to the spectre of Communism is one of the more desperate tactics used by those who are threatened by the shift to passive investing. It’s an extreme version of the 'inefficient market' argument with the insinuation being that passive investors are seeding their own downfall because only active players can ensure the efficient allocation of capital by rewarding good companies with rising share prices and punishing bad companies by selling their shares. However, while active investors drive market efficiency on aggregate, the SPIVA rankings show that their performance does not persist on an individual level. Over 10-years, a shocking 73% to 94% of GBP denominated active equity funds underperformed their benchmarks – ranging from emerging markets to UK equities to global equities. (Ref: SPIVA Europe Mid-Year Scorecard 2018)

There is plenty more evidence to show that the long-term interests of investors do not align with the short-term results needed by active managers to keep their jobs. Many active managers solve this problem by becoming 'closet index trackers'. Essentially they fear deviating from the index as underperforming the market increases their chance of being fired. So they end up charging their investors excessively high fees for performance that could have bought more cheaply from an ETF. The impact of high charges has been clearly illustrated by the FCA who concluded that an investor paying typical index tracker fees would earn 44% more on their investment than if they paid typical active fund fees, assuming average FTSE All-Share growth (Ref: FCA)

 

ETF investors underperform

Studies by Utpal Bhattacharya et al have revealed that some retail investors do underperform using ETFs. However, the problem has nothing to do with passive investing and everything to do with investors using ETFs as a tool to pursue an active, performance-chasing strategy. Underperforming investors typically make bets on short-term country or industry trends but mistime their trades and panic when the market moves against them. 

Buy and hold ETF investors who hold a global portfolio can safely ignore Bhattacharya’s findings. 
 
ETF portfolios versus active fund portfolios

ETF portfolios versus active fund portfolios – who wins?

Discover why ETFs beat active funds even more handsomely at the portfolio level.
More about the competition
 

The best long-term investment for retail investors

Retail investors cannot afford the risk of underperformance inherent in active investing, which is why Warren Buffet, among others, recommends index trackers. Given that past performance is no guide to future performance, even wealthy institutions regularly fail to identify winning active fund managers in advance, despite all the resources they can deploy in the search for skill. Retail investors stand virtually no chance of winning this game except by luck. 

Granted, ETFs are not perfect. However, the overwhelming bulk of the evidence shows that cheap index trackers are the best vehicle by a mile for retail investors. The market shift to passive shows that realisation is spreading, so expect the chorus of ETF criticism from the active fund industry to increase as they try to defend their turf and justify their fees.

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