The ETF versus Active debate refuses to go away and die. Over the last few weeks, this debate has even resurfaced in the mainstream media with Gillian Tett of the FT – amongst many others – worrying that the humble ETF could be the next threat to the financial system hiding in plain site. Her ETF related article is here – https://www.ft.com/content/a859449e-7daf-11e7-ab01-a13271d1ee9c. The excellent Chris Flood also has an article on this subject here – https://www.ft.com/content/8720939e-7e82-11e7-9108-edda0bcbc928
I have to say that I groan every time this debate resurfaces, not because there aren’t perfectly legitimate questions to be asked of ETFs. The problem is that the potential evils pinned on ETFs aren’t the ones featuring in the debate. Most chatter misses the point by shooting the messenger rather than looking at the underlying cause.
Now, it’s important to say right up front that although I am something of an evangelist for passive funds and ETFs (two very different investment propositions that obviously share many characteristics) I’m also no ideologue when it comes to active funds – I am happy to use both and both will continue to prosper.
One of the daftest debates of recent years has been the suggestion that passive may become so massive that it’ll crush active managers and turn investment money into brain dead, machine driven, index tracking zombie like nightmares. If only there that was even a remote possibility! Despite the amazing advances made by ETFs they are still a fraction of the total funds universe and frankly even if they did get above 50% penetration (remember there’s a shit load of legacy assets that aren’t like to turn passive any time soon) I’m fairly certain we’d see an immediate sensible reversion of mean favouring active managers. By this I, mean that the weight of passive money would create obvious opportunities for the right active managers to grab funds. The idea that active managers will die off is laughable in the extreme and I imagine that smart, idiosyncratic active managers with consistent strategies for alpha can’t wait for the day when passive becomes the biggest wall of money. Until then we should stop worrying – passive and active will continue to co-exist. Both have their place, and both will ebb and flow over time. End of story. On my own personal account, I’m perfectly happy to run a core passive portfolio – say via a robo adviser – alongside properly active investment trusts.
Many critics of ETFs also love to pounce on the rise of smart beta – it’s a giant marketing ruse they proclaim that will end in failure. I have some sympathy for this view but if we’re getting into the kettle calling the pot black scenario why can’t we also shine the spotlight on other marketing crazes, perpetrated by active manager such as the cult of the absolute return fund? That hasn’t ended well has it??
The more substantive debates around ETFs rest on two key observations.
The first is one based on liquidity in times of stress. What happens when all that ‘dumb’ money heads to the door at the same time in the next crisis? Surely, we’ll see liquidity issues emerge as a mass of orders fail to get processed in time? The smart commentators focus their attention less on equities – where liquidity is deep – and more on corporate bonds, where liquidity is undeniably much weaker. It’s a fair criticism but it misses the central point. ETFs are just the messengers – the transmission mechanisms – of a deeper problem, in this case being shallow bond trading liquidity. Fix this problem and make the trading in bonds as liquid as equities and we’d contain the issue.
The other perfectly legitimate worry is what I call the dumb wall of money argument. With so much money in say US blue chip ETF trackers, it’s making an already expensive market, even more overpriced. In essence this is the momentum, hot money argument, powered by strong behavioural incentives. I can’t for one minute argue with the logic that says too much hot money is chasing the deep liquidity of US blue chip equities but I don’t think that’s an ETF problem. ETFs might help make the pre-existing problem worse, but they are not the cause. The real problem lies in investor behaviour and the patent inability of many to understand what value investing has taught us – momentum trades eventually snap back and hurt everyone. Crucially I would argue that the equally large pool of what I call “May as well be dumb money” – closet index trackers pretending to be active – is also guilty. Managers will argue that they’ve twiddled their portfolio exposure nobs when it comes to risk exposure for the FAANGs but in reality, they are powering the same momentum trade as many ETFs. Again, ETFs are the messenger and transmission mechanism for more general, pervasive dumb investor behaviour.
Now, there are some specific ETF structuring issues that I DO think need closer attention. I’d offer up three bones for contention.
The first is that the sheer scale of money invested in volatility trackers in the US is a wonder to behold. A huge amount of money is being invested in ETNs which track the Vix index, with much of that money in effect acting as a hedge on a tumble in the S&P 500. Now, it goes without saying here that the underlying index CANNOT be physically tracked, forcing it into a synthetic options trade. Nothing wrong with that but at some point one has to worry whether the tail is wagging the dog rather the reverse i.e whether activity in the huge pool of liquid futures is actually beginning to warp the physical trade in the real underlying assets – the securities in the S&P 500. One also begins to worry about the counter party strength of those issuing leveraged VIX trackers!
My next bone of contention is in a related vein. As more and more ETFs stray into alternative asset classes, one does begin to worry about whether some underlying illiquid asset classes really have the right liquidity and trading structure to support an ETF, even a synthetic one. The more illiquid the underlying asset the more I worry about an ETF tracker – and switch back into actively managed investment trusts.
Last but by no means least we also need to keep our eye on increasingly exotic indices, some of which might be provided in house by the issuer. Investment banks have long been treated with some suspicion for their internally created indices, with many worrying about front running. If a huge wall of money is flooding into a benchmark index, transparency is needed. Index companies will need to be closely inspected by the regulators and make full disclosure of all fees and of all index data to as wide as possible a customer base. We simply can’t have a situation where an index developer hides index data, restricting information. They need to bring out research papers explaining the pros and cons of their index – they also need proper back tests, and they need to explain the risk profile of the index. In effect, they are the marketers of the index strategy, not the issuers, and the weight of explanation and marketing belongs with them. Crucially they shouldn’t be the same organisation as the issuer of the ETF.
This observation I think blends into a wider point. Too many ETF issuers behave like ‘investment flow’ engineers. They come up with an ETF idea, get an index house to build a benchmark, and then issue the ETF with as little explanation as possible. Hey presto, job done, time to move on to ETF number 783.
As there’s no active manager to stick in video interviews, all the explanatory burden falls on the fact sheet and the website data. But data doesn’t tell you everything. It doesn’t give you an explanation of the strategy, a sense of when it might work and when it won’t. ETF issuers need to work as hard – if not harder – than their active peers in explaining what my ETF is and why I should buy it. That requires content, interviews, and context. Not just dry data.