ETF Research, ETFs 101

Are ETFs safe or risky?

Debunking the biggest ETF myths and addressing the criticism.

Content


Why do people criticise ETFs?

Anytime you see an article entitled “ETFs are weapons of mass destruction”, the author is likely an active manager begging to hold onto their dwindling market share due to poor performance.

Many are actually ‘benchmark huggers’ or ‘closet indexes’ – you are paying stockpickers high fees for mimicking the index which you can get using a low cost vehicle. ETFs are these exact vehicles to drive your wealth to its destination.

Anti-ETF articles and research get lots of media attention because their provocative headlines evoke fear in investors. Therefore, it is important to address the false criticisms and debunk the myths that ETFs have been getting.

Find out why we invest in ETFs

Myth 1: ETFs are getting too big and will collapse

With over 3 million indexes in the world (which over 7000 ETFs track), and only 43,000 investable companies, some believe that indexes and ETFs are in a bubble and distort fundamentals.

However, the ETF market penetration is limited with Australian ETFs representing just over 2% of the entire Australian sharemarket.

An ETF is just a wrapper, a tool for accessing investments, and they cannot be explained for individual shares going up and down. They are designed to replicate and track their underlying index, so it should reflect the characteristics of those securities.

ETF flows have been increasing, but the underlying shares they invest in are also traded by thousands of active stock pickers trying to prove they can do it better.

Blackrock found that 80% of share trades are conducted by active managers trying to beat each-other in a zero sum game.1 The active vs passive battle should really be active manager 1 vs active manager 2.

For every winner there is a loser, and the average investor should perform in line with the market (which is what passive index investing is). Prices reflect the collective wisdom of every buyer and seller in a market.

Without ETFs, money would still be invested, but via active funds instead. Those active funds would own the same stocks, in the same aggregate weights, just for a much higher fee. Given active fund managers charge high fees, they most likely underperform the market in aggregate.


Graph shows the % of Global Share ETFs as a percentage of the overall Global Market Index.


State Street showed that global share ETF assets made up less than 10% of the global equity market.2 Meaning, the majority of global assets are still owned and managed by individual institutions, direct investors, and fund managers, not ETFs. We are not in a ‘ETF bubble’. Active managers are simply using this one for scaremongering.

Myth 2: ETFs cause price volatility and mispricings

Some say that ETFs have caused stocks to deviate from their ‘correct valuations’. However, active stock picking still dominates the trading process trying to determine what the price of a share is.

ETFs are not large enough yet to cause permanent changes to individual share prices. To say ETFs indiscriminately drive prices up and down is plain wrong.

ETFs are criticised for their flows moving markets. However, this cannot be further from the truth. BetaShares showed that during December 2018 in the USA, a month where the market had the worst monthly return since 1931, ETF flows recorded their highest flow for the year!3 This highlights the independence of ETF flows and individual share pricing.

Vanguard has also found no relationship between the growth in ETFs/Indexes and stock return dispersion.4 These Indexes have low turnover and only account for a fraction of all trading.

Market volatility has been around longer than ETFs, and volatility is driven by macroeconomic factors rather than ETF trading. Asset allocation decisions drive flows, not products like ETFs.

At Stockspot, we do our research, challenge myths and market commentary, and avoid widespread media noise mainly created by active managers who are fearful they are losing flows.

Myth 3: ETFs are not liquid

ETFs provide enough activity to ensure an active market of buyers and sellers. ETFs provide 2 layers of liquidity:

  1. The liquidity of the ETF itself
  2. The liquidity of the underlying securities.

The liquidity of the ETF has the visible liquidity (the average trading volume between investors), but if there are more units needed to fund orders, there is a deeper layer through intervention by market makers and the inventories they hold.

In larger markets like the USA, the most traded security is in fact an ETF, trading nearly 3 times as much as the next biggest security Amazon. 4 out of the top 10 shares traded in the USA market in 2018 were ETFs. Even though ETFs make up 8% of the USA market, it accounts for 30% of the trading volume.3

SecurityTrading Value in 2018 (US$B)
SPDR S&P 500 ETF Trust$6,631
Amazon$2,306
Invesco QQQ Trust Series 1$1,989
Apple$1,599
Facebook$1,170
Netflix$921
iShares Russell 200 ETF$911
iShares MSCI Emerging Markets ETF$853
Microsoft$799
NVIDIA Corp$774

Myth 4: ETFs do not cope well in times of crisis

Since the creation of the first ETF in Canada in 1990, there have been 3 global recessions which ETFs have all survived. During the 2008 GFC, investors actually bought ETFs and sold active fund managers, demonstrating that ETFs are seen as a trusted vehicle during market stress. During volatile times, ETF trading surges providing liquidity to those who need to trade.

The creation and redemption process behind ETFs means that they are actually better equipped for times of market stress, where active funds are more likely to put up the gates to lock up investor funds. ETFs are able to issue additional units or redeem units as demand rises or falls.

Myth 5: ETF issuers pose risk if they collapse

ETFs are a trust structure meaning if the issuer fails, the assets are not available to creditors, and the trust would continue to operate for the benefit of its unit holders.

If an ETF provider were to go bankrupt, given the assets are held separate from the issuer with a custodian, the trust would continue or the assets would be returned to the unitholders.

Find out how Stockspot makes it easy to grow your wealth and invest in your future.

Sources:
1 Blackrock: Index Investing Support Vibrant Capital Markets (2017)
2 SSGA ETF Education Session (2019)

3 BetaShares Global ETF Review 2018
4 Vanguard Research: Setting the record straight: Truths about indexing (2018)


Investment Associate

Marc has over 5 years experience in the financials services industry having previously worked for Morgan Stanley, AMP and KPMG. He holds a Bachelor of Business (Finance/Accounting) from the University of Technology Sydney (UTS), and has completed his Chartered Financial Analyst (CFA) Level 1.

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