On balance, ETFs have brought some good to the world
So, is the smart money with exchange-traded funds (ETFs)? We have done our best in the Age of the ETF series to lay out the pros and cons of the most successful investment innovation of our time. Being journalists, and with a need to act as watchdogs, we have tended to err on the side of the negative and ask, "What could possibly go wrong?" There are no apologies for that.
But let us look at what ETFs do offer. They provide all the benefits of passive management. They allow much more trading. And this has created jobs for a whole ecosystem around them: brokers who sell them to the public, stock exchanges, and the market-makers and brokers who ensure they stay in line with their benchmark.
That trading is excessive. In aggregate, those who trade heavily give themselves a worse deal. As shown by Jack Bogle, the Vanguard founder and a lasting sceptic of ETFs, the average investor in ETFs does worse than the fund itself. This is because the trading, usually mistimed, generally succeeds only in sparking value.
But by making money for all the people in the value chain, that excessive trading has sparked innovation in plenty of areas that might easily have been offered as open-ended passive funds but have not been. It is not a coincidence that the era of smart beta overlaps almost exactly with the point when ETFs achieved critical mass.
And innovation within ETFs is not just a question of smart beta — or building indices based on quantitative strategies designed to beat the market. ETFs have also moved into far narrower sectors than open-ended funds ever tried. Slicing and dicing markets by sector and geography, they have allowed a simpler way to express an opinion on the world either through active management (which involves entrusting someone else with discretion) or through open-ended passive management. And, of course, they have branched into new asset classes.
This has enabled a different model for brokers in the US. They are now fee-charging advisers, beholden to their clients, rather than reliant on fund managers for a commission. This is devoutly to be wished. They have no incentive to churn needlessly, but can trade easily if they want and offer a service based on asset allocation rather than their own (or a fund manager’s) attempts at stockpicking.
The arguments for the virtue of asset allocation can be overstated. It is true that asset allocation can swamp the effects of stockpicking. This has grown more pronounced with the correlations that have accompanied the growth of passive investing. And asset allocation can make you huge money.
Interest in asset allocation was most piqued by some famous academic research suggesting it accounted for as much as 90% of returns. This was exaggerated and misunderstood; Roger Ibbotson, whose work in this area is very influential, suggests it is more accurate to suggest that about three-quarters of a typical fund’s variation over time comes from the move in the underlying market, with the rest split between asset allocation and stockpicking.
Even so, as successful stockpicking grows ever harder, the appeal of a pure asset allocation approach is undeniable. At least it cuts out the fees of active management. By providing financial advisers with a financially viable way to make a living, while removing an incentive to rip off their clients, the new model of fee-based ETF allocation also improves the quality of financial advice that retail investors will receive as they guard their pension nest eggs.
Who pays for this to be possible? Ultimately, it is the people who spend their time trading ETFs and on balance losing money by doing so. ETFs have made wonderful toys for hedge fund managers, but they have not, in aggregate, made much money by doing so.
Over the past two years, the HFRX indices suggest that both macro and global hedge funds have lost money. Both have given their investors a far smoother ride than have the main ETFs for stocks and bonds, and both have marginally outpaced iShares’ ETF for long treasury bonds over the past two years — but many small wealth advisers, armed with ETFs, will fancy their chances to do better.
That service is ultimately subsidised by overtrading hedge funds. ETFs have brought some good to the world.
©The Financial Times 2016