The lowdown on ETFs

This is one of a series of columns that were produced for Moneyweb Investor in which Stuart Theobald explores the intersection of philosophy of science and finance. This followed an earlier series for Business Day Investors Monthly on the same theme. This column was first published in November 2015.

The rise of exchange-traded funds (ETFs) is a worldwide phenomenon. The first only came into existence in Canada in 1990, but 25 years later they are ubiquitous and now also encompass several other asset classes.  The JSE now sports 46 different ETFs and another 27 exchange-traded notes (which are just like ETFs but reference an index instead of replicating the index). Collectively they are worth R76bn, a drop in the ocean relative to the overall market capitalisation of R11-trillion, but more than double what they were four years ago and 10 times 10 years ago. Internationally, growth has been even more rapid, with $2.9-trillion now held by ETFs and ETNs worldwide in over 5 000 individual ETFs, according to research by the CFA Institute.

ETFs are a disruptive innovation that is affecting the business models of many operators in the financial markets. Chief among those will be actively managed funds such as the unit trusts that have for decades been the mainstay of the South African retail savings industry. ETFs are both easier to use and cheaper, with costs generally all below 1% a year, while unit trusts are typically around 2%, with additional upfront costs.

ETFs themselves have emerged in response to two other developments in financial markets. First is the growth of indexation. ETFs are index funds in that they invest in all the securities held in an index. ETNs pay a return based on a reference index, but rather than invest in a portfolio, the returns are guaranteed by a large credit worthy institution. ETFs have tracking risk in that the buying and selling of securities in the index may not match the movement of that index perfectly, while ETNs are designed to track the reference index perfectly. The creation of indices has become increasingly sophisticated, allowing for the isolation of specific instruments and features such as high dividend paying stocks (like the Satrix Divi+), or stocks with good black empowerment status (Absa NewFunds NewSA).

The second is the intellectual foundation for ETFs, the efficient markets hypothesis. This is the idea that markets efficiently capture all new information into prices. It follows that actively picking and choosing stocks is a waste of time and effort – you don’t know anything more than the market does. The efficient markets hypothesis is an idea many like to lampoon. We know in fact that market prices can be irrational, depending on just how you define “irrational”. The problem is that we’re only good at determining that in hindsight. When it comes to picking stocks and how they perform in future active picking is time and again shown to be no better than simply following the market.

These two factors, the technology of indexing and the intellectual basis of the efficient markets hypothesis, have been the main drivers of the explosion of ETFs. Their low cost has also helped wide-spread adoption as has the fact that they are listed on an exchange, and therefore can be bought and sold all day with liquidity and live pricing, further advantages over their unit trust cousins.

In South Africa another important helping hand to the growth of ETFs (though not ETNs) has been National Treasury’s decision to allow them to qualify for tax-free savings accounts (TFSAs). Stockbrokers are among institutions that can offer TFSAs, but those using them can only invest in qualifying ETFs and not individual equities. This was Treasury’s way of preventing overly risky behaviour, but will also have the effect of normalising ETFs as an investment destination among the public at large, much how unit trusts have been.

There are a few drawbacks to ETFs. The indexes they are based on are by definition less flexible than an actively managed portfolio can be. So they may not suit some retail clients if, for example, they have substantial existing exposures that need to be diversified away through a carefully constructed portfolio. Other issues may arise if ETFs continue their rise to dominate the market. The biggest potential risk is that price discovery is blunted. For the efficient markets hypothesis to work, prices have to move in response to new information. That requires active decision makers buying and selling. ETFs are effectively getting a free ride on these active decisions. But there is a long way to go in growth before that would become a real problem and there should anyway be a self-correcting mechanism. As the proportion of ETFs grows, tracking error would grow as price volatility increases. ETFs effectively heard in following price movements, so amplifying them. That leads tracking error to become an invisible cost so the returns to active investing would increase again.

On the whole, ETFs are the financial innovation of our generation. They should be a critical part of your investing strategy.