The case for ETFs
05 June 2018 | Topical insights
Eric Balchunas, senior ETF analyst with Bloomberg Intelligence, debunks recent criticism of exchange-traded funds and indexing. Please note that Mr Balchunas is not affiliated with Vanguard, and Vanguard makes no representation regarding his views.
Vanguard: Is the growth of indexing creating issues in the markets or with capitalism itself, as some have suggested?
Eric Balchunas: The headlines are over the top, and that's what the media often do. There are usually balanced voices in the articles, but the size of indexing can be vastly overstated. It's a classic mistake: The writer takes the percentage that index funds and ETFs make up of all fund assets and then applies it to the stock market. So he or she may write something like 45% of the US stock market is owned by passive funds. That's not true.
Only half of the $27 trillion [about £20 trillion] US stock market is owned by funds. The other half is owned by individuals, institutions and officers of the companies. Of the half that's owned by funds, passive is roughly 35% of that half and, therefore, 16% to 17% of the whole equity pie. ETFs then own a little less than half of that, or 7.4% of the stock market. That fraction of stock ownership isn't a threat to the capital markets.
Where is this criticism coming from?
A lot of these worries, and some downright attacks, come from active managers who write newsletters or complain about passive investments. The press picks up the arguments and sometimes runs them as gospel.
But let's remember: Active managers have a vested interest in criticising index-based competitors who are taking their assets. I'm just pointing out the truth here. But even if I or anyone else didn't point these things out, it wouldn't matter. Money goes where it's treated best.
If you look at the volatility in the first quarter this year, you see billions of dollars traded in ETFs. It's like a McDonald's sign: "Billions served." Most everyone had a positive experience with trading in and out of them or buying and holding them.
Because ETFs have a solid, loyal customer base, they are critic-proof and media-proof for now. The flows are as great as they've ever been because the customers themselves are loving life. A major publication may write a story that questions ETFs, but I don't see that story affecting how people invest. Advisers tell me clients will ask about it, but then the advisers will explain it and everyone just moves on.
But could indexing become so large that it would interfere with stock prices and market efficiency?
If only a quarter of the stock market was actively traded and setting prices, I think that would be fine. So we've got a long way to go before we get there.
If prices were moving in lockstep because so many assets were in index-based products, then you would see price dispersion compress. But we're just not seeing that. Not on a macro level and not on an individual-stock level.
General Electric's stock price has been dropping since early last year. During that time, the S&P 500 ETFs that hold a lot of GE have been hauling in a lot of money. But GE's stock price has still gone down. There are many cases where, if the stock is going to sell off, it sells off. The price of ExxonMobil stock, which declined steeply in the first week of February, is another example. I don't see where ETFs or indexing is affecting the fundamental pricing mechanism.
You've developed an 'ETF Stoplight' with red, amber and green indicators to help investors identify ETFs that may carry unforeseen risks. Why did you create this system?
The world of ETFs can be wild. ETFs have packed up nearly every investment that existed and some that did not exist before ETFs came along. There are sectors, asset classes, currencies, alternatives, derivatives. Okay, there's no farmland ETF and no digital-currency ETF. But barring a couple of areas, if you want to do it, there's likely an ETF for that.
Some ETFs are more complicated than others, so there needs to be a way to know which are which. ETFs needed a rating system, sort of like movies. Adviser networks have an approved list or a nonapproved list. In the media, you tend to hear terms like safe or dangerous.
I believe a heavily leveraged ETF is dangerous. Extra costs come with owning a product like that, and it is designed to be more volatile. A triple-leveraged oil-futures ETF? That should get the equivalent to an adults-only rating in the movies.
The yellow and red ratings in my system simply indicate that stuff in the product could be an unpleasant surprise to you. We look at leverage. Does it roll futures? Does it have hidden fees? You may have an ETF that shorts US Treasuries as an inflation hedge. You need to pay for that. There are other ETFs that are classified in the same area of tax law as collectibles and come with a higher capital gains tax rate. There are minor surprises and bigger ones.
Are ETFs helping to create a stock market bubble?
Blaming ETFs for the rise of the stock market is like blaming MP3s for the rise of a band you dislike. The ETFs are like the MP3. If people wanted to listen to that band, they could have gotten the CD, but the MP3 was a better medium. ETFs are a superior delivery vehicle: They typically come with lower costs and less in capital gains distributions. Many investors want the intraday liquidity.
Everyone assumes flows into index-based products are buying the same stocks. But passive isn't monolithic. ETFs include smart beta strategies and bonds. It's not as if ETFs are based only on market-capitalisation weighting. You can buy cheap stocks with ETFs that may not be as heavily weighted in the big indices. If you're nervous about equities, ETFs have fixed income. ETFs are just providing the tools for whatever you think you want.
Some people contend that passive flows are driving up the stock prices of big companies. But the large active funds tend to hold the same stocks: Facebook, Amazon.com, Netflix, Google parent Alphabet. If those famous 'FANG' stocks fell 40% in a day, should ETFs get the blame? No one blamed the 1990s tech bubble on active mutual funds, even though that's how most people got their exposure back then. Yet now ETFs are being blamed for whatever happens in the stock market.
What will happen to active managers if passive products continue to dominate flows?
Many advisers, I think, would have typically fired an active manager if he or she had too much tracking error relative to the S&P 500 Index. So, many active managers got in the habit of hugging the benchmark. But now that you can get the benchmark at a generally lower price, it changes the game.
I see the portfolio of the future, if not the present, as made up of a low-cost, index- and market-cap-based core, with expense ratios under 10 basis points. Then you sprinkle on some hot sauce on the outside: factors, themes such as environmental-social-governance, and active management.
Active managers don't want to be closet indexers. They want to make big bets; that's why they got into the business. So let them be fully active and charge a little more, because if they do, maybe they'll outperform their benchmark by 10 percentage points, worth their fee. That seems like the way forward for active. If so, some advisers will need to think differently about the role and form of active management.
Index funds and ETFs are being criticised for not being assertive on corporate governance. What do you think about that?
Yes, some of the asset managers are now the largest shareholders in many of these companies. But I find it odd. The press seems to think that index funds and ETFs have some sort of moral obligation to make these companies act 'better' in a way that active managers never had. The attitude is, 'Oh, they're active; they're just investing for short-term profits. We'll never bother them, but these ETFs do have that obligation. '
If an index fund owns a company, you could argue that it's a better owner because it can't get divorced. It can push on certain issues. It's not just concerned with short-term profit. It's just a different kind of owner.
What is your biggest concern about ETFs?
I have a concern about a potential effect I call vampiring. ETFs trade like crazy: Equity ETFs make up almost a third of all equity trading, if you count the ETF shares that trade on the secondary market, which do not need a creation or redemption. If ETFs ever got to half of all equity trading volume, it may show up in the premiums.
I can see the attraction: ETFs are so easy to trade that many active investors, including institutions, may decide to stop buying individual stocks and instead buy sectors as the smallest slice of the market they are willing to hold.
You don't want ETFs to steal too much from those who trade individual stocks and bonds. You want securities to be liquid. That liquidity means market makers will be comfortable keeping the bid-ask spreads tight through the arbitrage process, which means, of course, low premiums and discounts and, hence, low costs for the end investor or client.
If ETFs 'vampire' too much liquidity from the stocks they hold, investors may see incremental cost increases. The market makers will look at the basket and say the spread has to be, say, eight cents instead of four cents. The price will have to drift from the net asset value (NAV) a little longer before the market maker steps in and arbitrages that gap. The price you get on the exchange would be more expensive.
I'm not suggesting ETFs will blow up the markets. I'm saying that spreads in some sectors, such as REITs, could get wider if ETFs held enough of the underlying stocks. We also know that the market, by nature, tends to correct itself over time if prices vary from their fundamental value.
Do you have any other concerns?
There is another issue, and it is one that advisers can help alleviate. The potential problem with ETFs is that they are so easy to trade you can trade yourself into the poorhouse. A study out of Germany found that investors in ETFs did less well because they traded too much.1 Some of the measures around this, such as daily turnover, suggest that everyone is trading ETFs regularly. That's just not true. The real answer is that it's hard to tell, and we don't know which types of traders are trading.
Advisors should and do coach people to be prepared for sell-offs, so they're not tempted to do anything when the market goes down. I've also heard of advisers who allow people to trade a small, set portion of their portfolio, just to give them a sense of control, but not enough to affect their household finances.
As Vanguard research2 found, the greatest measurable value that advisers add is through behavioural coaching.
So how are advisers using ETFs?
All the money is going into cheap beta. Last year, index funds and ETFs took in $750 billion [about £563 billion] in new flows between them, and nearly seven in ten of those dollars went into products that cost less than 10 basis points.3
In the last two years, the asset-weighted average expense ratio for index funds and ETFs [in the United States] has dropped from 31 basis points to 23 basis points.4 You can build a portfolio at 6 basis points now. It's almost free.
Advisers now equate cheaper ETFs with the fiduciary standard. But advisers' need to show value to their clients is ultimately also part of this conversation. They want to show clients they've done their homework on the products. So they may go with some total-market-type funds and then sprinkle in a factor fund or active fund as their version of hot sauce. I think most advisers and adviser teams set their portfolios and then rebalance on occasion. But they otherwise go off to do all the other things advisers do, which is to serve their clients.
Senior ETF analyst, Bloomberg Intelligence
1 Jose Azar, Martin C. Schmalz and Isabel Tecu, 2018. "Anticompetitive effects of common ownership." Journal of Finance.
2 Francis M. Kinniry Jr., Colleen M. Jaconetti, Michael A. DiJoseph, Yan Zilberling and Donald G. Bennyhoff, 2016: Putting a value on your value: Quantifying Vanguard Adviser’s Alpha. Valley Forge, Pennsylvania: The Vanguard Group.
3 Based on data from Bloomberg Intelligence.
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