Why ETFs are proving attractive vehicles for investors

An increasing numbers of investors are being drawn to exchange-traded funds, lured by their low-cost advantages and promises of transparency and liquidity

 
The popularity of ETFs is booming like never before. Investors are attracted by their low costs compared with those of traditional actively managed funds
The popularity of ETFs is booming like never before. Investors are attracted by their low costs compared with those of traditional actively managed funds 
Author: Luján Scarpinell
February 14, 2018

“There is a lot in common between electric guitars and exchange-traded funds [ETFs],” according to Martin Small, BlackRock’s Head of US iShares. IShares is a global leader within the ETF market and part of the world’s largest asset manager.

“Every rock and blues song that has ever been written has its foundation in the pentatonic scale, which has five notes,” Small said in an educational video shown on the company’s website. In his explanation of the comparison between music and finance, he said that what makes music more interesting and allows people to add their own colour is the combination of those notes with a transforming technology, like an electric guitar.

ETFs can reflect, for better or worse, the performance of the assets they replicate, which can mean imitating either their security or volatility

The same, he said, is applicable to investment portfolios. Replacing the musical elements with market language, ETFs are investment vehicles that give investors a different approach to managing assets that have always been around, such as stocks, bonds, commodities and real estate. Through the use of ETFs, Small said, investors can build an investment portfolio that better meets their needs. With various types of ETFs, those looking for returns are able to add as much colour as they want to their strategies.

Growing offering 

Beyond metaphors and comparisons, the popularity of ETFs is booming like never before. Investors are increasingly migrating to these vehicles of passive investing, attracted by their low costs compared with those of traditional actively managed funds.

According to the London-based consultancy firm ETFGI, as of October 2017, the global industry totalled 5,224 ETFs (see Fig 1) with 10,861 listings and assets of $4.43trn. The latter figure is 38 percent higher than that of the previous year.

Although ETFs have existed for some time, their success at present is a result of their growing popularity among institutional and individual investors following the financial crisis in 2008. This growth accelerated markedly in 2017, when ETFs beat previous records as a result of their increasing variety and complexity. Today, there are ETFs replicating almost every (if not all) asset classes, with the ability to suit all tastes.

According to ETFGI data, in the US alone – the US being the market that best reflects current ETF trends – the previous year’s record annual inflow of $390bn was exceeded in the first seven months of 2017. ETFGI predicts that the global industry will keep up this pace, and the value of ETF assets will skyrocket up to $9trn by 2020.

Reasons behind the boom

ETFs will turn 28 years old in Canada in 2018, and will celebrate their 25th anniversary in the US. However, it was not until a decade ago that they became tempting in the eyes of investors.

Rebecca Chesworth, Senior ETF Strategist at State Street, SPDR Exchange Traded Funds, gave the phenomenon some background: “Among the many reasons why ETFs have accelerated, there is one long-term cause: there is a huge [structural] change going on. More people are investing in ETFs as they discover them, because there’s a learning curve and once investors understand the advantages, they change their behaviour. And that’s something that we see continuing.”

The vehicle is now luring in investors of all kinds, with individuals in particular – especially in the US – increasingly choosing ETFs due to their convenient costs. In Europe, although the segment is lagging behind, analysts expect the retail market to open up throughout 2018, when the MiFID II rules comes into force in the EU.

In the last few years, ETFs have built their own reputation away from mutual funds, as they both have similarities as well as strong differences. For a better understanding, it’s worth contrasting some basic notions: first, mutual funds are essentially pools of assets from many investors. These funds administrate that money on investors’ behalf for a fee. Similarly, ETFs also allow investors to bet on a basket of assets, without requiring them to pick individual shares or other assets.

However, the main difference between mutual funds and ETFs is that the latter trade in stock exchanges. ETFs also differ because they’re designed according to a specific index (such as the Dow Jones), asset (gold or bonds) or basket of assets (for example, the US tech sector), which they then track. For this reason, experts often refer to them as hybrids between funds and shares.

According to Hortense Bioy, Director of Passive Fund Research, Europe at Morningstar: “Many studies show that investors would be better off investing in ETFs rather than [actively] managed funds because over the long term only a minority of active managers beat their benchmark.” ETFs, on the other hand, provide plenty of opportunities. Another virtue is that ETFs cover a wide range of investment opportunities, making it easier for investors to gain exposure in markets that would otherwise be more difficult to access. Bioy added: “The breadth of choice is unparalleled, as they provide access to the furthest corners of the market.”

The growth of ETFs over the past decade has brought about not just more in number, but also more complex and diverse varieties. To mention just one of the almost infinite possible combinations, the New York-based fintech company iBillionaire created an ETF that tracks a portfolio of 30 of the S&P 500 stocks that are preferred by Wall Street’s most prolific investors, such as Warren Buffett. Through this ETF, investors
can imitate them.

Low costs and risk levels

There are even more reasons for ETFs’ growing global popularity. Versatility is one of these: as ETFs are flexible, “investors can use them tactically” and “hold them for the long term, short [sell] them or lend them”, according to Bioy. However, the fact that ETFs involve lower fees than many other types of investments (in particular, their cousin, the mutual fund) is even more valued by investors.

Furthermore, in some jurisdictions, such as the US, ETFs are also tax-efficient. Bioy explained: “This is because in the US, funds have to pay capital gains tax. So, every time a fund sells a stock at a profit, it has to pay tax on that profit. But ETFs don’t need to sell stocks when they rebalance. They redeem in kind, so ETFs don’t have to pay capital gains tax.” While this has been a key driver for ETFs’ growth in the US, in most jurisdictions in Europe, funds are not subject to capital gains taxation. Consequently, mutual funds are not at a disadvantage against ETFs there.

Transparency is a further attribute on the ETF’s list of strengths. Chesworth believes this increases their reliability: “Investors can see every single hold in the fund, unlike mutual funds. Thus, ETFs offer a lower risk in the sense that investors understand what they’re buying – for example, if the ETF has got good liquidity and they can trade out quite quickly.”

Nevertheless, how risky certain bets are is something that has to be considered at the asset allocation level. ETFs can reflect, for better or worse, the performance of the assets they replicate, which can mean imitating either their security or volatility.

However, by the very nature of ETFs and their composition, there is another risk-related distinction that must be considered: funds can be classified either as ‘physical’ or ‘synthetic’, each of which involves a different exposure. In the former case, the ETF provider actually owns the physical asset, whether it is gold, bonds or another asset. In contrast, the latter provider holds derivatives rather than the underlined assets – for instance, futures of gold or options.

While some analysts recommend avoiding synthetic ETFs because they involve a counterparty risk, others believe those risks are usually well managed. In any case, physical ETFs have been leading recent growth.

Ongoing success

In spite of their classification, ETFs’ rapid multiplication has raised concerns among some financial experts who think they pose a risk to the global economy. Anastasia Nesvetailova, Director of the City Political Economy Research Centre at City, University of London, addressed the main issue:  “The problem with ETFs, as ever with financial innovations, is ultimately not with their individual structures, but in how these instruments respond to a serious wave of volatility or a market shock.” Indeed, ETFs have yet to be put to the test by any kind of crisis.

Even though the presence of ETFs may still be small at a global scale, Nesvetailova said: “The main danger is the ‘unknown’ component of ETFs, and specifically their liquidity in stress times.” She also warned: “Being aggregate variables by composition and responding to market dynamics, ETFs may exacerbate a market meltdown, in the case, for instance, of a liquidity crunch.” History has shown “what is enjoyed during benign economic times can become toxic when the music stops playing”.

Despite some early warnings, ETFs are set to continue soaring as a result of increased education, regulation, technology, innovation and competition. “All of these factors will play a role in the future of ETFs in Europe, and globally,” said Bioy. With regards to education and technology in particular, Bioy thinks there’s still a lot to do in order to expand the use of ETFs, as there “still needs to be better availability of ETFs on platforms to encourage greater usage of [ETFs]”.

Similarly, Chesworth sees “no reason for this positive trend to slow down”. With strong forces on the rise and economic growth looming on the horizon, the way seems paved for ETFs to keep up their current momentum.