Exchange Traded Funds: the race is on

Growth of Exchange Traded Funds seems unstoppable, yet their importance in the financial markets is still limited

Like an Olympic 100-meter sprint, Exchange Traded Funds (ETFs) may beat the competition in the margins. They incur lower operating costs than actively managed funds and, when compared with mutual funds, offer investors more flexibility because, unlike mutual funds, the shares of ETFs are tradable on stock exchanges on a daily basis. ETFs — which are index-trackers — may well win the race against active fund managers. However, their performance warrants a closer look.

Assets in the global ETF industry have grown at a sprinters’ pace, averaging an impressive 20 per cent annual asset growth over the last four years. This brings their total market cap at $4.2 trillion dollars of which $2.7 trillion in the US. Though impressive, index funds — be they ETFs or mutual funds — represent just over 12 per cent of the US equity market and slightly over 7 per cent of the global equity ecosystem. The speed at which the industry grows, makes it therefore easy to overstate the weight it pulls in the financial markets.

Moreover, the perception that the rapidly growing ETF industry eats into the stock market and affects stock pricing is misguided. Douglas Yones, head of ETFs at the New York Stock Exchange (NYSE) reckons that ETFs do not necessarily boost more investment, but rather represent a transfer of the way assets are held. The growing trade via ETFs does therefore not affect the underlying securities of the exchange. It is simply an investment vehicle that allows investors to easily trade in and out of diversified portfolios without touching the underlying assets. The increase in ETF share trading should therefore not be misconstrued with the increased trading of the underlying securities. This additional sleeve of liquidity lowers the tariff barriers to investments in less liquid asset classes and allows a constant price exploration of the underlying security.

The popularity of index funds among investors is reflected by the sizable inflow of new capital they received over the years. Between 2007 and 2016, index funds experienced an inflow worth $1.4 trillion dollars whereas actively managed funds suffered an outflow of $1.1 trillion. This shift of capital flows does not, however, represent a market disruption, but rather a change in investment strategy of asset owners. To suggest that active fund managers are losing to ETFs is therefore a misconception according to Shelly Antoniewicz, senior economist at the Investment Company Institute, a fund association. “Active management is not disappearing, rather, there is a trend where active management is moving from inside mutual funds to outside mutual funds. Financial advisers are increasingly taking a more active role in managing their clients’ assets and they are using index-based ETFs and mutual funds to implement their active strategies.” ETF gains do therefore not come automatically as a loss to active fund managers.

Nevertheless, keeping costs low has become more important to all funds according to Michael Fitzgerald, head of Exchange Traded Products at Vanguard, an investment company. “Cutting costs is necessary because costs have a corrosive effect on performance.” The structure of an ETF permits this more easily because it tracks an index as opposed to actively picking securities. But in this instance, it is again worth taking a closer look. Though many ETFs do indeed offer lower expense ratios (management fees), there are exceptions. Vanguard’s VFIAX S&P 500 index tracking mutual fund has a lower management fee than the largest ETF on the market. Whereas the VFIAX nets 0.04 per cent, StateStreet’s SPDR comes in at 0.0945 per cent. It is economies of scale that allow large mutual funds to undercut the management fees of even the largest ETFs.

This shows that looks can deceive as the competing funds race towards the finish. “The ETF is a useful tool. Just like a screwdriver, it is useful for some investment purposes but not for everything”, according to Michael Sapir and CEO of ProShares, an ETF provider. Ultimately, the investors need to understand the competing investment vehicle before picking their champion.