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ETFs: haters gonna hate

Anthony Fensom  |  11 Oct 2017Text size  Decrease  Increase  |  
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Record inflows into US exchange-traded funds in 2017 have sparked fears that such passive investment is fuelling a market bubble that could end badly.


But others point to the many benefits offered by ETFs, with an increasing diversity available to Australian investors seeking a low-cost, convenient, and transparent product.

The growing popularity of ETFs globally is shown by recent data. Investors injected some US$391 billion (A$502 billion) into US ETFs in the first seven months of 2017, easily surpassing last year's record annual inflow of US$390 billion, according to consultancy ETFGI.

With some US$2.8 trillion in inflows since 2008, the surging popularity of ETFs has added to the US stock market's eight-year bull run. Yet fund managers have warned that ETFs, which now account for up to a third of US trading activity, are risking capitalism itself by inflating asset prices and exacerbating the effects of any downturn.

"It is not clear where ETFs and index mutual funds will find buyers for their holdings if they have to sell in a crunch," Oaktree Capital's Howard Marks warned the Financial Times.

However, other analysts suggest there is little evidence of ETFs causing market inefficiencies or increasing volatility. Fund managers such as Fidelity point to the benefits of such funds, including their diversification, low cost, and transparency.

Australia's exchange-traded product (ETP) market has swelled to more than $30 billion as of August, with 212 ETPs currently trading on the ASX. The biggest inflows in August were into international equities ($347 million) and fixed income ($150 million), with local equities seeing $16 million in outflows, according to BetaShares.

Yet unlike the US market, ETFs make up less than 2 per cent of daily turnover on the ASX, with around 10 per cent of the local market in the hands of passive investors, according to Credit Suisse.

Morningstar's associate director of manager research, Alex Prineas, suggests talk of an ETF bubble crashing the market is somewhat overblown.

"We've had market bubbles long before we had ETFs. ETFs were only a minor phenomenon in the GFC, and were tiny when we had the 'tech wreck' in 2000," he says.

"My view is that market bubbles are caused by irrational investors, or irrational behaviour from central banks or companies. That's not to say we shouldn't worry, as there's definitely some hot money flowing to ETFs, but to me that just suggests investors are seeing ETFs as an efficient and low-cost way to access the market.

"If there is hot money, then that money will find a way to get into the market, whether investors buy shares, managed funds, hedge funds, or ETFs. Certainly, it's worth looking at ways to improve products or regulation, but causing market bubbles isn't something I'd ascribe to a particular investment vehicle."

Prineas points to the structural factors behind the rise of ETFs, including their low cost, convenience, and transparency, although he thinks it unlikely for the local bourse to reach US levels of trading.

"In Australia, the biggest institutional investors here might use locally listed ETFs for their Australian equity exposure, but they can quite easily bypass local listings for their global exposure and go directly to New York. So, while there's scope for increased trading in Australia, it's doubtful it will reach US levels," he says.

As stated previously by Morningstar, the local market is seeing a growing range of ETPs covering a range of asset classes, including local and international equities, bonds, currencies, and more exotic strategies such as smart beta.

Recent offerings have included a number of cash, short-term, and floating-rate ETFs, although Prineas points out it is important to consider the potential risks and returns involved.

"Just because they use cash or short-term bonds in their title doesn't mean they're interchangeable--investors should really make sure they understand what they're investing in," he says.

Passive versus active

Amid an ongoing debate between passive and active managers, Prineas suggests both have their role, with passive favoured in US equities and ASX-listed property.

"US indices have proven hard to beat and active managers haven't had a great record in outperforming them. You can now get US equity products for as low as 4 to 5 basis points per annum, which is incredibly cheap," he says.

For property, Prineas argues that most active managers cannot add much value given the limited number of large capitalisation listed property trusts.

However, he sees active managers as having an advantage in small-cap ASX stocks, given the "large number of low-quality stocks in the space."

"Active managers have been able to do better than the index in avoiding the duds--whether it's the poor-quality mining or mining services stocks over the last decade, or in the previous decade the speculative tech names," he says.

Looking ahead, Prineas expects even more exotic ETFs to be launched, in areas such as strategic beta, alternative or structured products, and hedge funds.

However, the ETF haters might have to wait some time before "active" becomes flavour of the month again.

"We know there are periods when active managers do well and when passive does better, as it has recently. It's difficult to say what the cause is or what might turn it around--it could be central banks removing their stimulus or something else," he says.

"The best active managers can beat the index, however, we still think passive index funds are well placed versus the average fund over the long run, even while passive won't always do better in any individual year."

As Taylor Swift sang, "haters gonna hate," but there is little reason to let them influence your investment strategies.

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Anthony Fensom is a Morningstar contributor. This is a financial news article to be used for non-commercial purposes and is not intended to provide financial advice of any kind. Opinions expressed herein are subject to change without notice and may differ or be contrary to the opinions or recommendations of Morningstar as a result of using different assumptions and criteria. The author does not have an interest in the securities disclosed in this report.

© 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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