Picture: 123RF/pichetw
Picture: 123RF/pichetw

The frenetic success of exchange traded funds (ETFs) will not result in a market meltdown, say its supporters.

ETF products had another great year in 2019, with net inflows of $570bn (according to ETFGI, a research firm based in London) bringing total assets under management to $6.3-trillion.

But though this is a vast sum, it is still small in relation to the $127-trillion universe of publicly traded investments worldwide.

Still, the difference doesn’t quite capture the dominance and concentration ETFs enjoy among some instruments, most notably the S&P500, where they cumulatively own about 20% of all shares in the index.

And for many years ETFs have enjoyed the lion’s share of every new dollar saved in the US.

Critics, like Financial Times columnist Jonathan Guthrie, openly question what type of custodians and corporate watchdogs giant ETF companies like Vanguard, BlackRock and State Street will be.

That is, if passive investment begins to dominate the shares in issue of individual companies, how will these passive instruments behave when it comes to corporate boardrooms?

"The greater the dominance of a few investors, the worse for shareholder democracy," warns Guthrie.

Conventional methodology dictates that when a company enters an index, an ETF which tracks that index must buy that company’s share, and vice versa for those falling out.

In other words, ETF investors are rendered indiscriminate buyers (and sellers).

So as the volume of money poured into these instruments continues to rise, will this create distortions in the prices of the underlying assets?

Nerina Visser: Changing trends in ETFs. Picture: Supplied
Nerina Visser: Changing trends in ETFs. Picture: Supplied

Nerina Visser, ETF strategist at etfSA, says those arguments simply don’t hold water, because analysts need to distinguish between the trade in ETFs and the trade in the underlying shares the ETF represents.

"The market cap of the index-tracking industry might be at a certain percentage of the overall market, but the proportion of trading relative to the market is significantly lower than the rest of the market," says Visser.

That’s because ETFs "only access the primary market when there is a creation or cancellation of units, as opposed to the likes of unit trusts that only operate in the primary market and have to access the underlying market every day", she says.

She does concede that in highly illiquid instruments, an ETF purchase could move prices.

"Where there might be rising risk is when you are dealing with underlying investments that are not very liquid, like the African sovereign bond market. A sharp increase in demand might require trade in the primary market, but that is a very rare problem."

Deborah Fuhr, head of ETFGI, which has been tracking the development of the industry, agrees.

"One in 10 ETF trades are in the actual underlying stocks [primary trade]. So secondary trading in the ETFs themselves makes up the majority of the volumes generated by passive products," says Fuhr.

If anything, says Fuhr, ETFs are actually suppressing trading volumes, as ETF investors typically hold the product for longer.

By her count, more than half of ETF investors own a product for longer than two years.

This contrasts with the average tenure of just 8.3 months for a stock listed on the New York Stock Exchange.

Visser also points to the changing trends in ETFs, saying the initial products, which relied on selecting companies based on the size of market capitalisation, has evolved.

"The industry has also moved on from the products that were initially created and now, in addition to continued growth in more traditional products, there has been strong growth into products covering factor-based and thematic investing."

Factor-based investing uses performance-focused criteria — much of it copied from active managers — to select stocks that might outperform the market, based on factors other than just a share’s sector or market capitalisation.

"It’s no different to the underlying investment taking place, it’s just being offered in a much more consistent mechanism. There are no new risks created," says Visser.

Examples of "thematic" investing include environmental, social and governance factors (ESG).

"ESG is becoming very popular, especially in Europe. The Australian bushfires have forced many people to realise that climate change is real, and we are seeing demand growing for these types of products," says Fuhr.

With over $7-trillion in assets under management, much of it in ETFs, BlackRock, the world’s largest asset manager, announced in January that "environmental sustainability" would be a core goal of all future investments.

While BlackRock can do little to exclude high carbon emitters from traditional indices, its CEO, Larry Fink, promised to use the votes the company exercises as the custodian of shares owned on behalf of clients "to move more aggressively to vote against management teams that are not making progress on sustainability".

He also promised to "press companies to disclose plans for operating under a scenario where the Paris Agreement’s goal of limiting global warming to less than 2° [Celsius] is fully realised".

Which goes back to the point that so-called passive investment might not be all that passive in the end.