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Aligning ETF strategies with investor needs

29 November 2019 | Mark Fitzgerald

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Commentary by Mark Fitzgerald, Vanguard's head of Product Specialists, Product Management, Europe.

For many, the biggest appeal of exchange-traded funds (ETFs) is the simple yet revolutionary way they are structured: pooled investment funds, but which are bought and sold on an exchange, just like individual shares.

As increasing numbers of investors have embraced this blending of collective investing with the trading flexibility of a single security, the ETF market has undergone rapid growth over the past decade.

In Europe alone, ETF/ETP assets have grown almost six-fold since 2008, rising from around US$ 150m (€ 135m) to nearly US$ 900m (€ 809m) today1.

Unintended side-effects

As more investors have entered the ETF market, this has attracted a host of new ETF providers, each in turn offering a variety of ETF products. In one sense, this competition has served investors' interests as many of these providers have sought to compete on cost or service.

Downward pressure on costs is among the biggest benefits to investors of the flow of funds into ETFs and indexed products. Another advantage is the enhanced transparency ETFs offer investors, not only on costs, but also on underlying constituents and performance versus the benchmark.

But this market growth has also led to rapid product proliferation—the number of ETF/ETP products in Europe has almost trebled since 2008 to more than 2,350 today2.

The benefit to investors of this explosion in the array of ETFs available is more dubious, as greater product choice does not necessarily lead to better outcomes for all investors. The thousands of different ETFs on offer could actually distract investors from the most important factors determining investment success.

Many of these ETFs offer investors cost-effective access to a wide range of markets. In fact, the vast bulk of the assets invested in ETFs are in large, liquid, low-cost and diversified indexing strategies. These can be used as long-term, core building blocks of portfolios, not to mention a range of other functions.

However, there are also hundreds of smaller ETFs offering niche exposures which, individually, do not attract large amounts of assets.

While they are not a large part of the ETF market, investors should treat these niche strategies with caution. For one, they have limited value for the vast majority of investors. What's more, they could expose investors to more risk than they are comfortable with, or aware of.

Narrow focus

Some ETFs, for example, provide investors with narrow exposures to extremely small pools of assets. These include ETFs that track indices in countries with small, less-developed financial markets.

Apportioning appropriately weighted investments to these indices can form part of a broadly diversified portfolio. But disproportionate exposure to these less-liquid markets can expose investors to much higher volatility than they might be used to in more developed markets.

Another trend is the increasing prevalence of thematic ETFs. These typically provide targeted exposures to a specific industry or sector that some investors consider to have promising growth opportunities, such as drone technology, 3D printing or care for the elderly. At the end of 2018, thematic equity ETFs made up more than 3.5% of the European equity ETF market by assets, up from 2.7% the previous year3.

While these ETFs can help focus a portfolio around specific investment ideas, diversified they are not. Should the theme in question hit economic or regulatory headwinds, investors could find themselves exposed.

Heightened risks

A number of ETFs are unsuitable for all but the most sophisticated of investors. These products are not designed as core buy-and-hold strategies—in fact, attempting to use them this way can be extremely damaging if investors don't fully understand the way they work.

Leveraged ETFs, which seek to provide investors with multiples of an index's returns, are one example. These have a one-day investment horizon, after which they are re-set. This is hardly what most investors would consider a long-term investment period.

Beyond a day, holders of leveraged ETFs can be exposed to losses that may be much larger than they anticipated. Inverse ETFs, which attempt to provide the opposite return of an index, have a similar risk profile. There are more than 300 leveraged or inverse ETFs available in Europe, representing around 1% of total European ETF market assets4.

Owing to their unsuitability for most long-term investors, some regulators have taken steps to restrict retail investors' access to these higher-risk ETFs5.

Vanguard's philosophy

At Vanguard, we have a strict product philosophy under which we only offer ETFs that meet the long-term needs of investors.

Any product we launch must first correspond to these investor-focused principles:

  • Does the strategy have enduring investment merit?
  • Can it be used as core building-block exposure in a portfolio?
  • Can Vanguard deliver a best-in-class product relative to its peers?
  • Can we deliver it at low cost?

We believe ETFs that meet these criteria give investors the best chance for investment success and only these products make it as a Vanguard ETF. Those that are not true to our values simply don't make the grade.

But not all ETFs are held to the same standards as Vanguard's. When you are next reviewing the thousands of ETFs available to investors in Europe, consider how they stand up against these criteria.

1 Source: ETFGI, 30 September 2019.

2 Source: ETFGI, 30 September 2019.

3 Source: Deutsche Bank AG/London, 13 May 2019.

4 Source: ETFGI, 30 September 2019.

5 Source: FINRA, Investor Alert - Leveraged and Inverse ETFs: Specialized Products with Extra Risks for Buy-and-Hold Investors, August 18, 2009 https://www.finra.org/investors/alerts/leveraged-and-inverse-etfs-specialized-products-extra-risks-buy-and-hold-investors

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Important risk information:

The value of investments, and the income from them, may fall or rise and investors may get back less than they invested. Past performance is not a reliable indicator of future results.

ETF shares can be bought or sold only through a broker. Investing in ETFs entails stockbroker commission and a bid- offer spread which should be considered fully before investing.

Other important information:

This material is for professional investors as defined under the MiFID II Directive only. In Switzerland for institutional investors only. Not for public distribution.

This material was produced by The Vanguard Group, Inc. This article is for educational purposes only and is not a recommendation or solicitation to buy or sell investments.

The opinions expressed in this article are those of the author and individuals quoted and may not be representative of Vanguard Asset Management, Ltd or Vanguard Investments Switzerland GmbH.

Issued by Vanguard Asset Management, Ltd, which is authorised and regulated in the UK by the Financial Conduct Authority. In Switzerland, issued by Vanguard Investments Switzerland GmbH.

 

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