Are ETFs mutating into the industry they were created in response to?

'Wolf in sheep's clothing'

Tom Eckett

a man wearing a black jacket

The late Jack Bogle had a famousdislike of exchange-traded fundsdespite founding one of the largest ETF issuers in the world, Vanguard. Was he right to be so concerned? The direction of travel for the industry might suggest so.

“Over the past decade, the principles of the traditional index fund have been challenged by a sort of wolf in sheep’s clothing, the exchange-traded fund,” Bogle stressed.

In the past, ETFs – like index funds – traditionally tracked standard benchmarks such as the S&P 500, MSCI World or FTSE 100 which offer broad market exposure that the majority of active managers found tough to beat.

One only has to look at S&P Dow Jones Indices’ bi-annual SPIVA scorecards to see how active managers have struggled in this low return environment since the Global Financial Crisis.

As Bogle said: “Do not look for the needle in the haystack. Just buy the haystack!”

Recognising the costand performance benefits of buying broad benchmarks, investors piled in – there are now $5.4trn assets tracking the S&P 500 – and many ETF issuers began offering exposure to these indices.

However, the market quickly became saturated with issuers unable to differentiate except on costs. This edge has nowalmost entirely disappearedwith ETFs now charging single-digit fees for most broad-based asset classes.

As a result, ETF issuers have been forced to venture into more niche areas of the market such as smart beta, thematics and active in order to differentiate from their competitors and charge higher fees.

In the US, active managers have started wrapping their strategies in ETF format to take advantage of the tax benefits on offer following a rule change from the Securities and Exchange Commission (SEC) that allows issuers to not reveal the basket of their holdings daily.

While ETFs are just a wrapper that allows issuers to incorporate a whole host of different strategies, active managers cannot avoid the elephant in the room – performance.

Is this an issue for an industry that is delving into more niche parts of the investable universe? Look at the clean energy saga that has rolled on throughout this year. By offering exposure to less liquid areas, there runs a risk that problems will occur, especially if flows start to drive performance in the underlying market.

As one industry source told ETF Stream: “The more complicated the strategy, the higher likelihood of failure.”

While Bogle’s concept of simply buying the market was certainly a boring one, the ETF industry would do well to remember this is what has delivered huge savings to countless investors over the past decades.

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