In this article we look at some widely believed myths about ETFs. Read on to find out why they’re either completely untrue or at least partly untrue.
ETFs don’t track just the stock market (also known as equities).
It’s an easy mistake to make. The first ETFs were all equity funds and they tracked well known stock market indices such as the S&P 500. Even now, most ETF press coverage focuses on equities and equity ETFs still dominate the market. Of the $4.5 trillion invested in ETFs worldwide, $3.6 trillion is invested in equity ETFs, according to BlackRock.
But there are ETFs out there investing in a wide range of other assets including bonds, commodities, currencies and property.
The vast majority of ETFs are passive which means they track indices by investing in all the constituents of an index. So a FTSE 100 ETF invests in all 100 companies in the index.
The idea behind efficient markets is that share prices should always accurately reflect all the information about a company at a particular time. Critics of passive funds say that markets can no longer be efficient if markets are dominated by passive funds. That’s because passive funds, by their very nature, buy all the stocks in an index. There’s no one evaluating companies, looking at the latest information about a firm, and deciding whether to invest in the share or not.
But the reality is that active funds still comprise a bigger overall share of the market than passive funds. So if stock markets have been efficient in the past, there’s no reason why that shouldn’t still be the case. If passive funds blindly investing across the market create pricing anomalies, there are plenty of active investors out there who can nip in to exploit those anomalies. If the anomalies are traded away quickly, the market is efficient.
Remember also that passive funds are often used by investors in an active way. In other words, an investor might decide to invest in Europe and Japan but not in the UK. That’s an active investment decision which can be implemented using passive funds.
Perhaps there was a time when active v passive was a binary choice, but not now. For starters, investors can use passive funds as part of an active investment strategy, choosing which markets and assets to favour.
Secondly, if it’s a binary choice, that ignores the rise of smart beta, also known as factor-based investing. Smart beta funds are passive funds, but they aren’t traditional passive where you track a well known index such as the FTSE 100. Instead smart beta funds follow particular investment strategies such as value or momentum. Smart beta funds are passive because they select stocks for the strategy following a mechanised rules-based process. Fund managers aren’t picking the stocks for a smart beta fund.
So although smart beta funds are passive, they do differ from ‘plain vanilla’ passive funds, and they offer another approach.
The most popular ETFs are still the ones that invest in large stock market indices such as the FTSE 100.
The argument goes that large passive ETFs won’t encourage competition between companies in an index because the ETF won’t ever benefit from the competition. Let’s imagine three supermarkets which are all listed on the same index and start fighting a price war. After a couple of years, supermarket A emerges as the clear victor while the rival supermarkets, B and C have both been badly hit. The passive ETF benefits from holding shares in supermarket A but also suffers from holding shares in B and C. So the competition hasn’t created value for any ETF that invested in the index which contained three supermarkets. That’s the argument anyway.
Various academics have fiercely debated this issue and there’s no firm conclusion that we can see.
However, even if passive funds are reducing competition in some markets, they are also doing some good by being long-term investors. Passive ETFs remain invested in companies year-after-year whereas many active funds buy in and sell out on a regular basis. The active funds’ short-termism probably isn’t in the best interests of the companies that the funds invest in.
This is really a myth about passive funds rather than ETFs.
The concern is that because investors buy every stock in in an index when they buy a passive fund, the whole basket will be sold if investors want to bail out if markets are falling. That means all shares will suffer in a crash regardless of their fundamentals. And because ETFs are so easy to trade, selling ETFs could mean the rout becomes more indiscriminate.
But even if you accept the above concern, ETFs aren’t really causing the crash. Perhaps they may speed up the crash but no more than that.
And anyway, there are signs that the ETF investor base is becoming more diverse than in the past with a wider range of retail and institutional investors. This means there should be a range of views and objectives should help to balance supply and demand.