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Two opposing views on exchange-traded funds

Glenn Freeman  |  24 Jul 2017Text size  Decrease  Increase  |  
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Are exchange-traded fund (ETF) flows inflating a dangerous bubble, or simply a natural market reaction to higher fees from the active fund universe?


On the pro-side, David Bassanese, senior economist with ETF specialist Betashares, pours cold water on claims passive strategies are distorting the market. This argument "presumes that the magnitude and direction of flows into the equity market would have been different had this money stayed with active managers".

"In terms of magnitude, however, it's far from clear that the rise of ETFs has seen a net increase in flows into the equity market," he says.

To support his view, Bassanese points to data from the Investment Company Institute, a US-based lobby group. Collected between 2007 and 2016, this shows actively-managed US domestic equity funds experienced a net outflow of US$1.1 trillion. At the same time, US$1.4 trillion flowed into passively managed US equity ETFs.

"Surveys suggest active participation by non-institutional investors in the US equity market remains below prior peak levels. And while certainly above average, outright price-to-earnings valuations have largely been pushed by historically low bond yields," Bassanese says.

"What's more, price-to-earnings valuations are still below the levels seen during the dotcom bubble, when passive investing played a much smaller role."

He believes it is difficult to draw a clear connection between the rise of passive investing and "a significantly different allocation of investment flows across different companies, much less poorer investor returns".

"Globally, the evidence suggests around 15 per cent of US large-cap active funds have tended to be merely 'closet indexers' in any case, and only 20 per cent could be described as pure stock pickers," Bassanese says.

"Overall, moreover, surveys also continue to suggest most active fund managers--irrespective of country--fail to beat benchmarks after fees.

"The rise of passive investing is not just because it's cheap, but because more expensive discretionary means of picking stocks does not tend to produce better results."


Exhibit 1: Australian listed ETFs*, assets under management


* Includes data up to end March for 2017;
** Domestic share estimated using ASX funds under management data.
Sources: ASX; Bloomberg; RBA


Proceed with caution

Peter Warnes, Morningstar's head of equity research, takes a less sanguine view on rising ETF inflows--particularly within certain types of ETF vehicles. He draws a parallel between the "origins of the global financial crisis, embedded in the sub-prime loans made by several US banks" and the rise of synthetic ETFs.

"I get apprehensive, even anxious, when I hear or see the word 'synthetic' used in the financial and investment world. I recall synthetic collateralised debt obligations among other synthetic or rocket science-engineered derivatives causing major grief in the aftermath of the GFC," Warnes wrote in a recent edition of Morningstar's Your Money Weekly.

Such is the growth of flows into ETFs, they account for around one-third ($100 billion) of daily stock-trading in the US. "The flow of funds into ETFs has been so powerful, Vanguard now has holdings of 5 per cent or more in 468 companies in the S&P 500. Vigilance by regulators and appropriate authorities will be critical," Warnes says.

He suggests investing via some of the thematic-based ETFs currently available is more consistent with short-term or day-trading philosophies than long-term investing, "getting immediate exposure to the market and driven more by the fear of missing out".

"It is the ultimate shotgun approach and has more of a trading than an investing bias," Warnes says. "I am not suggesting global markets are about to implode, merely pointing to what I believe could create pressure points in what is normally an efficient market, when markets ultimately correct."

Warnes emphasises his views don't extend to all ETFs, but those where "synthetics ... or complex structure is at work". In these instances, he believes there is "a potential counter-party risk, as the ETF is not matched with the underlying assets or benchmark".

Referring to the massive scale of inflows to ETFs in the US, Warnes says "hindsight shows not recognising positive or negative trends until after they occur can prove costly".

"As with most investment strategies, prudence and common sense should prevail."

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Glenn Freeman is a Morningstar senior editor.

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