Busting myths of ETFs

The growth trend is reflected in Canada. The Investment Funds Institute of Canada reports that 2018 was the third year on record in which ETF net sales exceeded those of mutual funds. (ETFs now account for more than 10% of Canadian investment fund AUM, up from about 5% in 2011.)

The growth story is underpinned by a shift to passive investing, states the EY report, which suggests passive funds will exceed active portfolio management within eight years. At the beginning of 2017, ETFs already accounted for half the asset base of all index-tracking funds, as noted by John Bogle in The Little Book of Common Sense Investing: The Only Way to Guarantee Your Fair Share of Stock Market Returns (10th anniversary edition, 2017). (Bogle, who died earlier this year, founded Pennsylvania-based Vanguard Group and is considered the father of index investing.)

Despite ETFs’ growing popularity, many clients don’t understand them. Mississauga, Ont.-based Credo Consulting Inc. reports that a survey of Canadian investors who don’t invest in ETFs found the main barrier is lack of knowledge, and 52% of survey participants said they don’t know what an ETF is. Hugh Murphy, Credo’s managing director, spoke at an ETF summit presented by Advisor’s Edge and Investment Executive last autumn. He said lack of knowledge about ETFs is a lost opportunity for mass-market households in particular, considering ETFs can be a cheap investment option. (Credo’s research was conducted on behalf of the Canadian ETF Association.)

Lack of understanding about ETFs may also be caused in part by criticism of passive investing. A 2018 report from New York-based S&P Dow Jones Indices LLC (SPDJI) stated that critics of passive investing sometimes “conflate issues that all market participants face with issues uniquely attributable to index funds.”

With these trends in mind, here are some experts’ responses to some common ETF misconceptions:

ETFs cause market volatility

One concern is that growth in passive investing through ETFs negatively affects the market quality of the underlying securities. Specifically, there’s concern that ETF trading substitutes for and takes away from the liquidity in the underlying securities, thereby increasing market volatility.

While volatility is, indeed, driven by an absence of liquidity, research published in the Journal of Portfolio Management found a positive correlation between volume changes in ETFs and their underlying securities refutes the claim that ETFs cause volatility, says Deborah Frame, president and chief investment officer with Frame Global Asset Management in Toronto, a division of Quintessence Wealth. The research also found that market volatility generally results from macroeconomic factors and geopolitics, which are what the market has been reacting to recently, Frame says.

Robyn Graham, a chartered financial analyst with a decade of portfolio management experience with two of Canada’s leading ETF-only asset managers, says volatility “tends to be more apparent as we get into the late stages of a market cycle and people are trading on every bit of news.”

Graham also notes that ETFs, as wrappers, have no inherent volatility. “It’s what’s in the basket that matters,” she says. Also, the ETF basket provides greater diversification, which is “inherently a volatility-management tool” that helps to manage risk among the underlying securities, she says.

ETFs make the whole market think and move the same way, resulting in inefficiencies and potential bubbles

This misconception also focuses on passive investing. The idea is that with passive investors “buying” an entire index, market pricing becomes inefficient, with higher correlations (a measure of returns) among equities.

Such inefficiency is potentially true only during short time intervals, says Craig Lazzara, managing director and global head of index investment strategy with SPDJI in New York. If this scenario were true over longer periods, the average correlation of stocks in an index would increase and remain at a high level, he says. In fact, correlations at the end of 2017 were at a 26-year low, and have been below their median levels since mid-2016 despite growth in passive assets.

This misconception may be based on a mistaken sense of the amount of assets attributable to indexing. For example, while the total amount of assets indexed to the S&P 500 composite index is roughly $3.5 trillion as of last year, that figure represents only about 10% of the total value of all stocks in that index, Lazzara says. Even considering all first-generation indices (not smart-beta indices), that figure is about 20%-25%, he says.

Lazzara says passive investing enhances market efficiency. For example, market competition from passive alternatives, including ETFs, results in an increase in the average active portfolio manager’s ability to generate alpha, as the least capable managers lose AUM, he says.

Addressing the concern that passive portfolio managers don’t contribute to market efficiency in terms of price discovery, Lazzara says price discovery is a function of trading, not of AUM, and passive AUM can easily rise further without significantly diminishing the percentage of trading volume done by active investors. For example, assuming that the annual turnover for passive and active AUM is 5% and 50%, respectively, passive AUM can rise to more than 83% of market AUM before active portfolio managers’ share of trading drops below 50%, the SPDJI report states.

Graham says the market remains a mirror of myriad investor viewpoints. Although passive investing constitutes a larger proportion of trades relative to years past, investors create a healthy dynamic as they follow their respective investment policies, she says. The next market crash, she says, will probably coincide with weak economic data or geopolitics, as is typical.

“I would rather be in ETFs during the next crash, because I know the liquidity is there,” she says. “We can execute our portfolio strategy tactically much more easily than if we were trying to unload a bunch of individual stocks, for example — some of which might be ‘no bid’ or out of business.”

ETFs are passive regarding shareholders’ rights

A criticism noted in the SPDJI report is that index fund portfolio managers may not be good stewards of investors’ assets if the portfolio managers are less concerned about company governance as they focus on keeping investors’ costs low. But, Lazzara says, the big ETF providers have increased their stewardship efforts in recent years, engaging with the management of companies in which they invest. “Indexers have [greater] incentive to interact with corporate management” because they can’t sell individual stocks.

Graham says ETF providers typically have stated policies for proxy voting — an important consideration for investors, given their increased interest in sustainable investing. Furthermore, she says, clients can choose ETFs that invest “responsibly.”

ETF investing is simple and requires no advice

Regardless of the tools used to invest, Graham says, clients need advice to ascertain their ideal asset mix based on their risk level and objectives. And, as portfolio tools, ETFs can be simple or complex. For example, a single balanced, active ETF may suffice for a do-it-yourself investor (see story on page 18), while a sophisticated portfolio manager may actively trade several ETFs daily.

Bogle recommended the Main Street investor avoid the wealth-eroding effects of costly trading. Thus, his investment advice remained unchanged as ETFs gained popularity during his lifetime: find an inexpensive, classic index fund and hold it for the long term. For clients who like the idea of sector ETFs, “invest in the appropriate ones and don’t trade them,” he wrote.

Frame describes ETF investing as an opportunity to access the part of the market driven by macroeconomics and geopolitics. Her firm uses broad-based ETFs to create model portfolios to minimize risk in various economic environments. That’s a skill set distinct from stock-picking, she says. Those skills are important, given a landmark 1986 study by Gary Brinson et al, entitled Determinants of Portfolio Performance, that found portfolio returns are determined largely by asset allocation, and only 10% by specific investments.

Investors most willing to pay for advice and those interested in ETFs may be the same clients. Credo’s research found that ETF investors are more likely to get advice compared with other investors (28% vs 19%, respectively). That may be the result of having sufficient investing knowledge to be aware of what they don’t know: the research also found that ETF investors are more financially literate than other investors — the former group scored 79% on a test vs 29% for non-ETF investors.