8 myths about ETFs

Shaun Port

a man wearing a suit and glasses

A lot of untruths are spoken about ETFs. So we thought we'd unpick the fact from the fiction.

1. ETFs are new

No, not quite! ETFs were first launched in Canada in 1990 and shortly after in the US in 1993. The first ETF listed on the London Stock Exchange came in April 2000. Over the last 10 years, assets held in US-listed ETFs have risen three-and-half times to $3.37trn, or 16.3% per year. In Europe, ETFs have grown five-and-half times to $0.73trn, or 18.6% per annum.

2. ETFs are run by a computer

Well, computing power helps all investment managers look after their portfolios, including how we manage our client portfolios at Nutmeg. But, rather than being run by a computer, quantitative models help real people ensure that the ETFs they manage track markets very efficiently. The teams that manage ETFs are experts in their field, but we find that some teams are better than others. This is why we carry out an extensive process of due diligence to choose the best ETFs, out of more than 2,000 listed on the London Stock Exchange.

3. Markets are more volatile because of ETFs

If we look at the US financial markets, where ETF assets are significantly higher than other markets and regions, US equity ETFs still only accounted for 7.5% of US equity markets in 2018, whereas US mutual funds accounted for 19.5% of assets. In fixed income, US ETFs accounted for 2.9%, whereas mutual funds held 20.7% of assets.

So, the level of assets held in ETFs is still very low. But it is not just the assets that are important, it is the turnover in these assets. For US equity mutual funds, turnover was around 64% in 2018, whereas for US equity ETFs it was 7.7%. Based on these numbers, trading by equity mutual funds has 22 times the market impact of ETFs.

It is also worth noting that when ETFs are bought and sold this does not always result in the underlying securities being bought and sold. Whereas, if a mutual fund is sold by an investor, the underlying securities are required to be sold.

When market volatility increases, ETF trading volume increases as well. This is because when the price of stocks tend to swing in a wider range, this can create opportunities for market participants to arbitrage the market price of the ETF against the market value of the stocks held within the ETF portfolio. From this point of view, ETFs are not the cause of market volatility; they are traded more frequently as a reaction to market volatility as investors respond to market events.

4. ETFs have never been tested in a crisis

There have been three global recessions since 1990, and plenty of episodes of financial market stress through those past 28 years. ETFs have come through these episodes unscathed. During the worst of the global financial crisis in the fourth quarter of 2008, US investors sold $198bn of bond and equity mutual funds. In the same period, they bought $73bn of ETFs, signaling that ETFs are trusted in a time of crisis. The same thing happened in the large market correction at the end of 2018: Over the fourth quarter, US bond and equity mutual funds' sales were $309bn, whereas the US ETF inflow was $105bn.

Predicting what will cause the next financial crisis is an incredibly difficult task. Undoubtedly, ETFs will be affected by the next crisis, just like mutual funds, but we doubt they will be the cause.

5. ETFs are only good for equities, not bonds

ETF launches were initially focused on equity markets, where investors gradually began to accept that stock pickers couldn't beat the market. It is now becoming more accepted that active managers struggle to beat the bond market as well.

Over the last 10 years in the United States, assets held in equity ETFs has increased by 14.7% each year, whereas for fixed income ETFs the growth is 27.6% per annum.

The largest bond ETF, with the ticker AGG, holds more than 7,000 bonds in the US, with assets of $58bn. Bond ETFs are increasingly used by large institutions rather than other securities, like derivatives, to get exposure to bond returns.

6. ETFs are passive on shareholder rights

BlackRock and Vanguard are the largest asset managers in the world, with the largest passive funds. They are also very active shareholders.

One of the largest holdings in our socially responsible portfolios is the UBS MSCI ACWI Socially Responsible UCITS ETF. Between February 2018 and January 2019, UBS engaged on just under 5,000 company votes for the securities held in this portfolio, voting 450 times against the direction of company management.

As long-term investors with limited ability to divest from index holdings, stewardship and governance remains of the highest priority to passive investors.

ETF myths

7. ETFs are a simple solution for individual investors, not investment professionals

The truth is that while ETFs are popular with individual investors for their transparency and low cost, institutional investors make up a large portion of ETF users. This is particularly true in Europe, where professional investors such as wealth managers, asset managers, pension funds and insurance companies make up a large portion of the user base.

According to a survey by Greenwich Associates, large European institutional investors increased their use of ETFs by 50% in 2018, with growth driven by several factors, including that "ETFs thrive in volatility". We have previously described ETFs as one of the investment industries best kept secrets, so it's no surprise that industry practitioners are amongst their biggest users.

8. ETFs are less liquid than mutual funds

In our view, ETFs may have the advantage when it comes to liquidity. This is due to the secondary market that exists for ETF shares - meaning the units of the fund can change hands without requiring the trading of the underlying assets. Should an investor not be able to buy or sell the volume required on the secondary market, investors can default to the same route as mutual funds - buying or selling the underlying securities to create or dismantle the ETF units - known as 'trading in the primary market'.

In our view, the two layers of liquidity available in ETFs are an improvement on the one layer available in mutual funds. In other words, ETFs are able to continue to trade, when the underlying securities are not, providing investors with more freedom to shift their risk if they need to.

Shaun Port is chief investment officer at Nutmeg.

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