This article focuses on Exchange Traded Funds, or ETFs--what purpose they serve, why demand for ETFs has grown, and Federal Street Advisors’ position on the use of these products. We discuss how ETFs have evolved in recent years, and examine their risks. We also consider some unintended consequences that may result from their design, consequences that have implications for the market as a whole.
A Quick Refresher On The Efficient Market Theory
An economist and his companion are strolling down the street when they come upon a $100 bill lying on the ground. As the companion reaches down to pick it up, the economist says, “Don’t bother; if it was a real $100 bill, someone would have already picked it up.”
Would you listen to the economist’s advice and walk by the $100 bill? Probably not. If you saw a $20 bill on the ground, you’d probably pick it up as well. Similarly, as an investor, if you felt strongly about the prospects of a company and felt that the price was not reflecting those prospects, you would most likely invest. Yet we’re repeatedly told by “experts” like the economist above that there are no bargains in the stock market, that mispriced opportunities just don’t exist. In fact, we’re taught that markets are efficient, meaning that prices fully incorporate and reflect all available information. Others insist that with so many investors looking over the same stocks, any bargains would have already been scooped up. Taken to the extreme, the most orthodox version of this “efficient market theory” suggests that one cannot outperform the market through picking stocks. It implies that opportunities in the capital markets always trade at their fair value, so don’t even bother trying to do it yourself.
If you are the economist from the joke above, you will not grab that bill. In addition, you will believe that markets are efficient and will not try to outperform. Instead, you will buy the entire market rather than strive to identify the best securities or managers. You can do this easily by investing in “index funds” or by purchasing “Exchange Traded Funds” (ETFs) that seek to track the market in a passive manner, and at a low cost.
History Of ETF Investing
When first introduced in 1990, ETFs provided a new, cost-efficient alternative to more traditional index mutual funds. ETFs offered new bells and whistles, including greater liquidity (since they can be traded intraday) and the potential for greater tax-efficiency. The downside risks associated with greater liquidity and intraday trading are the risks of large bid/ask spreads (the difference between the price offered by the buyer and the price requested by the seller) and tracking error introduced by purchasing and selling shares during the day at prices that vary widely from the closing price of the index for the day.
ETFs Have Evolved To Become A Massive Mover Of The Markets
The world of ETFs looks much different now than it did two decades ago when the first ETF was launched. There have been enormous structural changes in the market over the years, and increased investor demand has led to explosive growth in the number of ETFs. At the end of 2000, there were just 92 ETFs globally; by the end of 2010 there were close to 2,500.1 As shown in the graph below, since 2007 equity ETFs have garnered more than $680 billion of net inflows, during a period when more traditional equity mutual funds have incurred $460 billion in net outflows. Just within the past 12 months, the combined assets of the nation’s ETFs increased by $289 billion, or 28%.2
Furthermore, a conflict of interest might arise if the ETN fund provider is owned by an investment bank. The ability of the investment bank to choose the collateral creates an incentive for them to use balance sheet assets for which they would otherwise have little use, including lower-quality assets that are costly to fund.
A paper on this topic written by the Bank for International Settlements (BIS) explains that by posting these less liquid stocks and bonds as collateral assets to the ETN provider, the investment banking unit can effectively fund them at no cost, benefitting from reduced warehousing costs. 5 By moving these less liquid assets to the collateral basket, the bank may profit from a reduction in mandatory regulatory capital charges since they have effectively substituted their lower quality equity collateral with investors’ cash (which regulators view more favorably).6 While part of the cost savings may be passed on to ETN investors through a lower expense ratio—seemingly providing an advantage—there is the risk that if the counterparty failed, the ETN provider would be forced to sell these low quality, less liquid collateral assets which could result in a significant markdown and losses for investors.
While some of these issues relate more specifically to synthetic ETF products, they are a prime example of how financial innovation can add layers of complexity to a seemingly simple idea. As we continue to see a profusion of new vehicles labeled as ETFs within the industry, it is especially important for investors to understand the nature of these products and the risks that they encompass before getting involved.
Federal Street’s View On The Role Of ETFs
At Federal Street Advisors, we believe that the capital markets are somewhat efficient, and we acknowledge it is difficult to identify attractively priced securities in a consistent manner over the long run. However, we also believe it is possible to outperform the market, and have indeed been successful at helping many of our clients accomplish this task. We conduct extensive research to identify exceptional third party active investment managers who are, in turn, able to apply their substantial resources and experience to identify the most attractive securities.
We believe these managers are experts at identifying stocks or bonds of companies whose prices do not reflect their true values. Since our clients, without our guidance, would most likely invest in a set of index funds rather than our recommended active investment managers, we provide a clear comparison of their portfolio’s performance to an appropriate mix of index exposures.
An index Fund Can At Times Play A Valuable Role Within Our Clients’ Portfolios
Once we identify an area of the capital markets that offers an attractive return opportunity and should be included in a portfolio, we look for the best manager to execute on that mandate. If, however, we are unable to identify a manager that we believe will be able to outperform, we will not hesitate to recommend an index fund to achieve the desired market exposure. Given the available options, we normally prefer index funds to continuously traded ETFs.
Conclusion
At Federal Street Advisors, despite the proliferation of ETF investing, we continue to look for exceptional investment managers that actively research companies, distinguish between those that are weak versus those that are strong, and find ways to benefit from disconnects in price and value. It just makes sense. Ironically, ETF investing may help make these managers even more successful; we are hearing from some managers that the increased use of ETFs may very well lead to a greater disconnect between price and value in many areas.
With fewer analysts striving to determine fair value, fewer investors taking a long-term approach, and more investors placing their faith in efficient market theory, we strongly believe that those who gain insight from their fundamental work will have a greater advantage going forward.
1http://www.blackrockinternational.com/content/groups/internationalsite/documents/literature/etfl_industryreview_q111.pdf
2http://www.ici.org/research/stats/etf/etfs_12_12
Total combined assets in US ETFs were $1.34 trillion in December, according to the ICI.
3Driehaus September Fund Summary page 5
4http://www.cbsnews.com/8301-505123_162-37640420/etfs-and-the-flash-crash/
5BIS Working Papers No 343: Market structures and systemic risks of exchange-traded funds
6http://www.cfainstitute.org/learning/products/publications/cfm/Pages/cfm.v22.n5.7.aspx