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The Rise and Rise of ETFs

by internationalbanker

By John Manning – International Banker

Stock markets have undergone some fairly seismic structural changes over the last 10 years or so. Arguably the most ground-breaking of these changes has been the advent of exchange-traded funds (ETFs). Whilst once upon a time, markets were focused almost exclusively on buying and selling stocks, the expanding universe of the ETF is now rapidly becoming the trading instrument of choice for investors around the world. In the words of Jack Bogle, founder of one of the world’s largest asset-management companies Vanguard, “from a modest beginning, ETFs’ impact on stock trading has now reached mammoth proportions, and ETFs now account for nearly one-half of all trading in US stocks”.

The rise of the ETF is among the most significant events to happen to financial markets in recent times, not least because of its astronomical surge in popularity. It was first launched in 1990, when the Toronto Stock Exchange created a fund to track the TSE 35 Index. A few years later, the SPDR S&P 500 ETF—which tracks the US benchmark stock market—came into play, and rose to become the world’s largest ETF, a title that it continues to hold to the present day. Indeed, the SPDR S&P 500 turns over more than $14 billion worth of trades every day, dwarfing the $3 billion per day traded in Apple shares, the most actively traded single company in the world. This provides some indication of the magnitude of the ETF revolution, while further evidence lies in the sheer number of ETFs in existence, which grew from 1,184 at the start of 2008 to 4,874 by the end of February 2017, and which range from equities, precious metals and infrastructure to private equity and possibly even bitcoin in the near future. The total value of assets managed in ETFs also exploded during the same period, from $807 billion to a whopping $3.68 trillion—while of the world’s seven most heavily traded equity securities, five are ETFs at present.

They have become the most sought-after form of passive investment—that is, the investment strategy that tracks an index, or a specific basket of companies. A significant proportion of new money flows are accounted for by passive funds, and are thus making significant inroads into the space of long-term investor savings—a space once clearly dominated by traditional mutual funds. Indeed, as the world of ETFs expands, the world of mutual funds is concurrently shrinking. According to data from Morningstar, last year saw $130.7 billion leave from US mutual funds, while $240 billion flowed into US ETFs.

Both ETFs and mutual funds involve packages of securities in a fund. In the case of mutual funds, the fund manager will normally invest in stocks on behalf of clients that he/she thinks will earn the best returns, and thus beat the market. In contrast, investing in an ETF that tracks a particular index will result in the money being allocated according to the proportional weighting of the index. If a stock represents 0.6 percent of the S&P 500, for example, then $0.60 of every $100 invested in the ETF will be allocated to that stock. That said, passive funds have continued to develop more sophisticated trading strategies to enhance their gains, the most successful of these being smart beta funds, which not only track indices but also have the ability to identify the mispricing of assets.

Mutual funds are also open-ended, in that investors can regularly pay into or withdraw from the fund, while ETFs passively track an index and investors buy and sell shares traded on an exchange, with new shares bought and sold by market-makers to ensure they move in line with the value of the fund. With ETFs, therefore, nothing is directly added or removed from the fund itself. Furthermore, the structure of ETFs gives rise to several specific advantages over mutual funds. For a start, investors can trade throughout the day at the latest price, whereas investors can only pay into mutual funds once a day according to the closing price. The costs associated with investing in ETFs tend to be markedly lower than those of mutual funds in addition, with the management fees of some passive funds sometimes as low as 0.1 percent.

The performances of the respective strategies in the real world, moreover, have also contributed to the investor diffusion from active to passive investment strategies, with perhaps the most glaring fact being that mutual-fund managers have simply failed to beat the market in recent years. For instance, 2016 saw more than 60 percent of actively managed stock funds in the United States being outperformed by their respective market benchmarks, as assessed by the S&P Indices Versus Active (SPIVA) funds scorecard. Mid- and small-cap funds performed particularly poorly, underperforming 89.3 percent and 85.5 percent of the time respectively, while large-cap funds were outperformed by the S&P 500 on 66 percent of occasions. When the performance is viewed over longer time horizons, things look even worse for active fund managers. The last 15 years have seen the S&P 500 perform better than a whopping 92 percent of large-cap funds, while the statistics only marginally improve for the mid- and small-cap funds, which were outperformed 95.4 percent and 93.2 percent of the time. In all, 82.2 percent of active funds underperformed their benchmarks over the 15-year period ending 2016. Clearly such numbers are bound to leave little doubt in the minds of investors that most investment managers are failing to accomplish the one task they are paid for: to beat the market. As such, investors are left with little choice but to choose passive strategies in their search for achieving the best returns.

Many of the problems for fund managers have arisen since the 2007-09 global financial crisis, with a distinctly more risk-averse culture permeating throughout much of the banking and finance industries. Whereas fund managers were previously rewarded for taking calculated risks in order to beat the market, the industry mind-set is now considerably geared more towards a “safety first” approach. During this time, passive funds have also been supported by the actions of central banks, especially following the injection of trillions of dollars of liquidity into the financial system via quantitative-easing programmes that, coupled with extremely low borrowing rates, have led to the distortion of asset valuations in the market. The rise in popularity of ETFs in the post-crisis period, therefore, has been particularly expedited. According to Cantor Fitzgerald, more than a quarter of all daily trading volume in the US is now comprised of ETFs. Bloomberg data, meanwhile, shows that the American ETF market currently holds $2.7 trillion in assets, with more than $160 billion of new flows into ETFs emerging so far in 2017 alone:

>However, some believe that markets are being overrun by funds, which in turn is creating problems of its own. As trillions of dollars have been poured into ETFs, a growing chorus of active fund managers have made clear their distaste for a product that has made justifying their existence increasingly challenging. Some managers have pointed to the fact that the huge sums of money being put into ETFs raise the risk of creating and inflating market bubbles, whilst others have suggested that such funds exacerbate market distortions, thus preventing the ability of markets to accurately price assets and efficiently allocate capital.

Perhaps they have a point. Researchers from Stanford University and Emory University in the US, as well as from the Interdisciplinary Center Herzliya in Israel, found that increased ownership of individual stocks through ETF investment widened the bid-offer spread in such shares, which in turn made them more expensive to buy and sell, and thus less appealing. The funds also cause specific shares to shed some of their unique price paths, and instead move more in concert with the wider stock market. According to the universities’ research, a one-percentage point increase in ETF ownership results in a 9-percent increase in the share’s correlation with its industry group and the broader market during the ensuing 12 months. Furthermore, the correlation between the stock’s price and its future earnings falls by 14 percent; its bid-offer spread widens by 1.6 percent; and absolute returns increase by 2 percent.

The study is just one of a handful released in recent times illustrating the problem of lower market efficiency as a result of the introduction of more funds. New York hedge fund Horizon Kinetics, for example, recently showed that the correlation between the S&P 500 and its largest constituents has dramatically increased over the past 20 years. With fewer trades on average resulting for each stock, market liquidity is also likely to be more constrained, while transaction costs may also increase. As such, many see ETFs as an undesirable addition to markets, with traders in particular unable to identify as many opportunities on the basis of research on earnings, valuation and other metrics.

Some have even resorted to labelling ETFs as “weapons of mass destruction”, such as Arik Ahitov and Dennis Bryan, managers of the $789 million FPA Capital Fund. Again citing the problem of heightened correlation between stock prices and the wider market, the managers also lamented the creation of markets that are increasingly separated from underlying fundamentals. According to Ahitov and Bryan, “When the world decides that there is no need for fundamental research and investors can just blindly purchase index funds and ETFs without any regard to valuation, we say the time to be fearful is now”. Seth Klarman, the noted value investor currently managing the $30 billion Baupost Group, meanwhile, told investors in February that as the popularity of passive investment increases, and as active management diminishes, “the more inefficient the market is likely to become”.

Although both the aforementioned research and the money managers make some pointed observations, not everyone is convinced. Goldman Sachs observed that passive investors constitute only around 14 percent of the S&P 500; although this figure is markedly higher than the 9 percent recorded in 2013, it still represents a fairly small portion of the market. Indeed, the total value of the US stock market has risen from about $10 trillion in 2008 to approximately $27 trillion at present; whereas, over the same time period, equity ETFs have grown from just $300 billion to $1.7 trillion. Even with all their publicised growth, therefore, they still account for only a little over 6 percent of the equity pie. State Street, meanwhile, recently stated that it saw no material deterioration in bid-offer spreads as a result of ETF usage, while correlation between S&P 500 members remains near record lows, almost 50 percent below the average over the past six years. It should also be mentioned that the FPA Capital of today is far from the headline-grabbing equity fund it was for the 25-year period to 2010, when it returned 14.5 percent per year and was widely considered among the top funds in its asset class. In recent years, it has put as much as 35 percent of its assets into cash, resulting in the fund underperforming its benchmark index by 66 percent and trailing 99 percent of its peers during the last five years. Bemoaning the impact of ETFs, therefore, suggests in some cases that the consequences of the funds’ own mismanagement during the last few years may have been somewhat ignored in the final analysis.

Whether all this means that the death of the traditional stock-picker is fast dawning upon us remains to be seen. Some, such as CEO Euan Munro of Aviva Investors, believe that the somewhat unique environment of low interest rates prevailing throughout much of the world—an environment that has helped to bolster equity markets during the decade—is soon “coming to an end”. Munro expects that active managers will be more highly sought after during the coming period, when markets are likely to experience more volatility. Under such conditions, more winners and losers are likely to present themselves at any one time. Professional fund managers will also have greater access to the latest tools, including big data, in order to identify investment opportunities.

At the same time, however, it appears highly unlikely that the growth in popularity of ETFs will abate anytime soon. They are providing a significantly more diverse range of investor sophistication with the chance to convincingly participate in financial markets, as well as arguably creating a new market paradigm in which it will seemingly take greater efforts by active fund managers to identify and exploit those market-pricing anomalies that yield favourable gains. Or indeed, ETF growth may also continue to create new types of market distortions, thus presenting additional opportunities for professional investors to capitalise on undervalued securities. As stated by CIO of Ritholtz Wealth Management,  columnist and blogger Barry Ritholtz, “ETFs and index investing attract capital because they are inexpensive and outperform the vast majority of active managers. Blaming ETFs for the woes of stock-pickers misses the lesson the market is trying to teach”.

According to PwC (PricewaterhouseCoopers), passively managed funds are projected to more than triple in asset value to more than $23.2 trillion by 2020, which would account for more than one-fifth of the $112 trillion of assets managed around the world. If so, then one can reasonably conclude that the age of the ETF is well and truly in full swing.


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