Cutting Edge September 2017: A review of the latest research into the passive funds space and asset allocation

David Tuckwell

Every month ETF Stream brings its readers what we believe is the very best in cutting edge (largely academic) research about the passive investing space and ETFs in particular - with an occasional nod to general asset allocation studies.

We kick off our review with what we think is quite the most interesting recent academic research of the last few months - it suggests that ETFs are in effect the Facebook of finance!

In a ground-breaking study entitled Two-Sided Markets in Asset Management: exchange-Traded Funds and Securities Lending, Jesse Blocher, and Robert E Whaley remind investors that "if you're not paying for the product, you're the product." This tag line was first flicked Facebook's way. Facebook let's its users use its website for free, but that's because it is selling them (its audience) to advertisers. But it could equally be applied to ETFs.

Asset management used to be a simple fee for service business. But ETFs have changed that. Modern ETFs cost so little that they're basically free, which begs the question: how do the issuers make money?

The answer: securities lending. And the turn to securities lending means asset managers have turned their clients, in effect, into their product as they provide the funds to lend out.

The evidence for this provided by Professors Blocher and Whaley is that revenue from securities lending is significant and can, in some instances, dominate the expense ratio. But the more damning evidence is that what's profitable to lend determines what securities funds hold.

One of the most cited study on the web in recent weeks is a paper called Inefficiencies in the Pricing of Exchange-Traded Funds by Antti Petajisto which examines ETFs trading at premiums.

It's easy for investors to look at the headline price of ETFs (their management fees) and take that as the major cost. But they're sometimes wrong to do so. A major cost for many ETFs comes from trading costs, which can create mispricing. It's a serious issue. With more than $2.5tr locked up in ETFs, any nontrivial mispricing can transfer significant amounts of wealth from non-sophisticated to sophisticated investors. Fortunately, however, most ETFs are priced efficiently.

The study observes that "Funds holding liquid domestic securities are priced relatively efficiently, whereas funds with international or illiquid holdings exhibit nontrivial premiums relative to NAVs, which is qualitatively consistent with the costs and uncertainty faced by arbitrageurs in these funds."

Another heavily cited paper of recent weeks looks at how ETFs decrease information flows and therefore pricing efficiency - the study is called "Is there a dark side to exchange traded funds? An information perspective" and its written by Doron Israeli, Charles Lee, and Suhas Sridharan. Finance theory gives two predictions on the possible impacts of ETF ownership on prices. First, that the ETF-arbitrage mechanism can improve intraday price discovery for the underlying stocks. This suggests that more ETFs mean better pricing of underlying securities, particularly in the short term. Second, a possible negative relation between ETF ownership and pricing efficiency. This is because ETFs promote investors exiting the equities market in favour of buying ETFs. With fewer knowledgeable equities traders, pricing inefficiencies are likely to rise.

This study finds evidence to support the second view. It finds an increase in ETF ownership can increase trading costs and that as more ETFs emerge, fewer analysts cover a firm.

In a study entitled Evaluating a New Hot Trend: The Case of Water Exchange-Traded Funds, Gerasimos Rompotis dives into the world of Water ETFs. Currently they are rather in vogue and promoted as part of SRI investments. They represent a chance to profit from water scarcity and climate change as well as urbanisation in the less developed world.

Crucially though they don't invest in the price of water. They invest in water infrastructure and water production. A Literature review on SRIs finds that there are three trends of note.

  • SRI funds make no difference;

  • that SRI's can outperform;

  • that they significantly underperform (this is particularly true in Australia, apparently).

Currently there are only four water ETFs listed on NYSE.

The bottom line of this study is that water ETFs don't deliver market-beating performance although they can keep up with the market. They therefore make a plausible SRI investment for those unconcerned with outperformance.

Indices that track the volatility of equity markets is the subject of another compelling paper - its author questions whether VIX ETFs work too well for investors' own good? VIX Exchange Traded Products: Price Discovery, Hedging, and Trading Strategy, by Christoffer Bordonado, Peter Moln√°r, and Sven Samdal examines how trading volatility has become commonplace this decade - volatility ETPs are now listed around the world to help investors track volatility.

Contrary to received wisdom that VIX futures can be used to diversify and hedge, this study finds VIX ETPs cannot be used to hedge, cannot be used for diversification and almost certainly lose money in the medium-term because of their negative roll yield (thanks to contango). In fact, the only time they work to diversify is during a financial crisis.

The bottom lines? "A position in the most popular direct VIX ETP, the VXX, would have lost over 99.5% of its value if opened in January 2009 and held to April 2014". These volatility related ETPs are untenable for buy and hold strategies. But because they track their underlying indexes well, they are useful for short term traders and speculators.

Last but by no means least one recent study argues that ETFs have made corporate bonds easier as an investment category. In The impact of innovation: Evidence from corporate bond exchange-traded funds (ETFs), Caitlin D.Dannhauser observes that Corporate bonds have historically been opaque and illiquid, and open only to specialist investors. But ETFs have changed that. Thanks to ETFs, corporate bonds are more available to retail investors, significantly more liquid and come with much smaller spreads.

"For nearly every measure of ETF Activity in both the high-yield and investment-grade markets, the proportion of retail trades decreases and mutual fund investment increases."


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