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5 myths surrounding ETFs debunked

Arian Neiron  |  28 Nov 2017Text size  Decrease  Increase  |  
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Exchange-traded funds (ETFs) are becoming an increasingly popular investment vehicle for Australian investors. Despite their success, or likely because of it, there are several myths being spread about ETFs distorting the stock market.

Some commentators argue ETFs will be the cause of the next bubble and are leading the financial world to ruin. Others argue ETFs are a fad.

Clearly, they are not a fad. Australia's exchange-traded product (ETP) market is set to finish the year with a projected $35 billion in assets, continuing its trajectory of steep growth with investors flocking to these low-cost, liquid, and transparent products.

ETP assets ended October at a record high of $33.22 billion, compared to $23.95 billion in October 2016, representing growth of 39 per cent. ETFs make up the majority of ETPs. The investment dollars are flowing into ETFs, and for good reason.

This article provides the facts behind ETFs and busts some of the common myths that exist today.

Myth 1: ETFs create bubbles and inefficiencies

A very common claim is that ETFs are creating the next stock market "bubble" and are responsible for market inefficiencies and volatility. The argument is that ETFs are driving up stock prices regardless of their fundamental value.

This is a myth. In Australia, ETFs do not own enough of the stock market to move it in any meaningful way. The ASX's total stock market value is $1.86 trillion, up from $1.5 trillion dollars in 2012.

In that time, ETFs grew from $10 billion in 2012 to be around $30 billion today, of which only around 40 per cent is invested in Australian equities.

So, even though ETFs have tripled in size, they still only represent 1.7 per cent of the stock market--not nearly enough to move it, let alone justify the claims they are creating the next bubble.

 

Measured in trillions


chart


Source: Bloomberg

 

The fact is, volatility in share markets is driven by macroeconomic factors such as GDP, inflation, and interest-rate movements, rather than the buying or selling of underlying assets by market makers.

Indeed, share market volatility was a characteristic of markets well before ETFs emerged.

This year has been characterised by a surprising lack of share market volatility, while the ETF market has continued to flourish.

Myth 2: ETFs impact market liquidity

Even though ETFs only own 6 per cent of US equities, they account for around 30 per cent of the trading volume--double what it was 10 years ago.

 

ETF dollar volume as a share of equity trading


chart


Source: NYSE, Bloomberg

 

Bloomberg claims this could present a problem as "if more and more people stop trading stocks and bonds in favour of ETFs, it will drive up trading costs in the underlying securities while potentially making it more difficult to exit on big sell-off days".

But in Australia ETFs currently represent just 2.5 per cent of trading volume. This is nowhere near enough to distort the economics of trading.

Myth 3: ETFs inefficiently allocate resources

Another criticism of ETFs is that because of their disproportionately large flows, ETFs have been distorting the market by buying stocks that active fund managers wouldn't necessarily buy.

The table below illustrates that active funds are buying the same stocks as the market capitalisation index in relatively similar proportions.

Below are the top five stock positions in the S&P/ASX 200, compared to three of the largest active managers. Stocks common to the S&P/ASX 200 top five are highlighted in orange.

You can see that the three equity fund managers hold the largest stocks on the ASX, in similar proportions held by the S&P/ASX 200.

 

chart

Source: Morningstar Direct, as at 30 September 2017

 

Myth 4: ETFs are a fad

ETFs have, in fact, been on the scene for almost 30 years. The world's first ETF was launched in Canada in 1990, and the first ETF listed in the US in 1993.

The first ETF in Australia was launched in 2001. Institutional investors were the first backers of ETFs and retail investors have been buying up ETFs since the early 2000s.

The rise of ETFs is part of the rise of passive investing. ETFs are passive funds that are traded on an exchange such as the ASX. They aim to track a benchmark index, in contrast to active funds, which seek to outperform a benchmark index.

The rise of passive investing since the GFC has coincided with a significant decline in investor appetite for active investing. This has led to the situation where global flows to passive funds far exceed flows to active funds, as the chart below indicates.

This is no fad but in fact a consistent movement that has developed over time. This trend is reflected in the growth of ETFs in Australia and shows no sign of abating through the end of the year, which we expect to end on another record high.

 

Cumulative flows to equity funds ($tn)


chart


Source: Bank of America Merrill Lynch Global Investment Strategy, EPFR Global, Morningstar

 

Myth 5: ETFs are riskier than managed funds

This is not true. ETFs are in fact managed funds, that is, investors' money is pooled together and managed by a professional investment manager.

ETFs are like unlisted "index" managed funds, which are designed to replicate the performance of an index or underlying reference assets such as commodities, a currency, or bonds.

Standard or "physical" ETFs buy the underlying investments (such as stocks, bonds, or other securities) that are in the underlying index. The fund owns the assets outright.

If you invest in an ETF, you will own units or shares in the ETF just like a managed fund and your main investment risk remains the performance of the underlying assets, that is, the risk that the value of the assets will rise and fall in line with index market movements.

The difference is ETFs have the added features of: 1) being traded on the ASX, which provides greater liquidity; 2) being fully transparent so investors know exactly what assets they are invested in; and 3) being generally lower-cost than equivalent unlisted managed funds.

Therefore, ETFs have better risk characteristics than equivalent unlisted managed funds.

The reality is that hysteria about ETFs is based on myths. ETFs are not creating a bubble nor are they inefficient or significantly distorting the market. Much of the negative focus on ETFs has been written by those who stand to lose the most: active fund managers.

The fact is, the ETF industry has recorded consistently high growth since its beginnings, which is likely to continue. Investors are using low-cost ETFs to access markets offshore and broaden their portfolios in a way they have never been able to before.

As more ETF products are launched in Australia, investor choice and inflows to the sector are set to continue to increase.

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Arian Neiron is the managing director of VanEck Australia. Established in 1955, VanEck is one of the world's largest ETF providers. This is a financial news article to be used for non-commercial purposes and is not intended to provide financial advice of any kind.

© 2017 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782 ("ASXO"). The article is current as at date of publication. 

 

 

 

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