You Can’t Spell ‘Apocalypse’ with E-T-F

by , 24th September 2018

Are ETFs victims of their own success? With a huge 40% growth rate in Europe in 2017, the focus of the media, regulators and pundits is turning more and more towards our $800bn European industry.

In many ways, we welcome this interest – the spotlight is creating more awareness and encouraging people to understand the many advantages that ETFs have to offer. On the other hand, it has been open season for scare-mongers, naysayers, professional worriers and click-bait pundits to attack ETFs with an increasingly hysterical and apocalyptic tone. It’s been 10 years since the financial crisis and people are looking for the next blow-up and, in some minds, ETFs are the new CDOs.

While ETFs are not an investment panacea, neither do we believe that are they a pandemic waiting to happen. Let’s look at some of the common accusations facing ETFs.

ETFs are Growing Too Fast and Cause Bubbles

There’s a common misconception that indexed-based ETFs may cause or amplify the effects of financial bubbles. A quick look at the size of the ETF industry relative to the overall fund asset base should quickly dispel any idea that ETFs are of a sufficient scale to impact overall markets and could neither be reasonably considered a likely cause of a market run-up, nor capable of triggering a crash. The European ETF market is just €800bn out of the total European fund asset base of €9.6trn (according to EFAMA) – what’s missed out in these statistics is that a significant proportion of assets in this figure are index-linked mutual funds that offer the same exposures as ETFs but with less tradability and higher costs. Markets drive ETFs to change in price, not vice versa.

ETF Liquidity Isn’t Guaranteed in Volatile Markets

Most of the allegations made against ETF liquidity can be made equally, if not even more emphatically, for mutual funds and other investment products. Contractual agreements and stock exchange rules mean that authorised participants (APs) and market makers have to guarantee two-way pricing continuously while the markets are open, and in the majority of cases there are multiple market makers competing for the business – at HANetf we are building one of the most extensive liquidity networks in Europe to support tighter spreads in our funds all of whom will compete to win trades from the market with competitive pricing.

Remember, if you buy an individual bond instead of an ETF, you are still in the same position if there is no liquidity – no bids for your bonds means you can’t get out and vice versa. The point that is regularly missed is that even when liquidity is low, ETFs provide investors with more trading flexibility, transparency of pricing and immediacy of execution than traditional fund products.

The last major market drop we saw in the UK was the day after the Brexit vote. The UK equity market fell heavily and that day there was about four times more ETF trading activity than average on London Stock Exchange.

Despite a falling market, despite a one-directional trade and unusually high trading volumes, the ETF market functioned as it should and investors were able to hedge or execute their trade quickly and without incidence. As liquid, transparent and tradable assets, ETFs are an ideal choice for investors who need agility. I’d rather have a FTSE 100 ETF than a FTSE 100 Mutual Fund when markets are moving and I need to get out fast.

Finally, despite the smooth functioning of the ETF markets the day after Brexit it’s worth pointing out that an ETF is not designed to solve liquidity issues associated with the asset class it represents. If there are underlying liquidity issues with an asset class then that will be reflected in any product- including an ETF.

ETFs Are Becoming Too Complex

While the earliest ETFs tracked simple, market capitalization indices like the FTSE 100 or S&P 500, recent years have seen a proliferation of factor and ‘smart beta’ strategies available as ETFs.

Importantly, these new products have not been created in isolation but are responding to investor demands for differentiated exposures and better tools to help them achieve their investment goals – if the market didn’t want them they would shut down and shut down fast. In previous years such exposures may only have been available in mutual fund or structured product format, but investors wanted to add the attractive characteristics of ETFs – transparency, liquidity and reduced ownership costs.

Additionally, for every UCITS ETF the issuer is obliged to make a great deal of material freely available on the fund strategy and a high degree of transparency on the underlying holdings – far more than is required for other products. If ETFs are becoming complex, at least this complexity is out in the open for investors to see, question and interrogate.

On top of this, ETFs are sold via brokers and platforms that are obliged to put their clients through a suitability test to ensure they are capable of understanding the benefits and risks of the products on offer. This extra check at the point of sale means that on-platform ETFs can only be sold to clients who are in a position to properly understand the benefits and risks.

Complaints are easy to make, but solutions are harder to find. ETFs are revolutionary products bringing many benefits and improvements to the mainstream investor experience – the adoption rate demonstrates their attractiveness and proves they offer something above and beyond what was available in the past.

Because ETFs offer a better investor experience, they will continue to grow an continue to expand into new areas.

That said, ETFs aren’t a silver bullet to solve every investment problem. What they are designed to do is offer access to a variety of markets, asset classes and investment approaches in a wrapper that has low minimum investments, is easy to trade in and out and is transparent – allowing the investor to analyse, question and judge the portfolio on offer.

These qualities alone are huge advantages and strengths relative to traditional investment products. As with every investment product, the onus is on the investor and their advisors to analyse and assess its merits and suitability.

Naturally transparent, ETFs provide the information and data investors need to make a fully informed decision and are streets ahead of comparable products in terms of transparency, cost efficiency and liquidity. There will be another market crisis and holders of ETFs will not be immune to the effects. When this happens I’d prefer to be in a product with more liquidity, trading flexibility and lower exit costs than not – I’d prefer to be in ETFs.