Everything I know about ETFs

Investing is a ubiquitous topic between family and friends and on social media. With so many options, so many voices offering, often conflicting, advice and an overwhelming amount of financial jargon it is hard to know where to start. Here I take a look at Exchange Traded Funds ETFs, specifically finding out how they work and their possible failures.

Tour of stock market financial instruments

According to the accounting equation assets equals owner’s equity plus liabilities (A = OE + L). There are only 2 ways a company can raise capital: either by increasing their liabilities (e.g issuing bonds or taking out a loan) or by increasing the owner’s equity by issuing shares. Raising capital through shares is first achieved at the company’s Initial Public Offering (IPO). Thereafter investors just trade shares with each other based on market sentiment for future returns. The company may declare to issue more shares later, but for the most part everyday investors trading shares are not adding any value to the company but instead are bidding for a share of future profits or expect the value of the business to increase over time.

Trading individual shares faces the following challenges:

• An investor buying individual shares should put a considerable amount of effort into understanding the company’s financial statements to ensure he/she is making the reasonable decision
• Buying individual shares are financially costly
• Given the previous two challenges, a small portfolio suffers from a lack of diversification and poses greater risk of loss to the investor

Efficient Market Hypothesis

The first challenge, investing time and effort to pick stocks, is the core of active investing. Active investors use considerable resources and expertise to analyze companies to determine which companies are most likely to provide the best return on investment. Their decisions are based of publicly available knowledge in the form of financial statements and news headlines. A market is deemed to be efficient if the current price of a particular stock is reflects all the publicly available information. It is in market inefficiencies are where active investors try and beat out the fellow investors. Anecdotally consider a trader has reason to believe the demand for a company’s product is going to increase in the coming years and therefore increase revenue. By factoring in this belief (information) he/she may buy a share before anyone else has had chance to realize this. The investor then profits off the information they have provided as more investors bid the price of the stock up when they also see this predicted sales growth. ¹

However herein lies the challenge of active investing, given the number of investors and resources at their disposal, the market for the most part behaves efficiently. It would take a considerable effort to find stocks priced below or above their fair value. The average investor who does not want to sink the resources into finding these market inefficiencies may wish to forego the additional reward for finding them. A passive investor can instead bet on the market as a whole by owning a cross section of it.

Mutual Funds and ETFs

To address the next two challenges, I will introduce mutual funds. Many are familiar with mutual funds, whereby investors pool their capital into a single fund (i.e “pot”). A fund manager builds an investment portfolio of stocks, bonds and cash with the expectation of some return. The fund manager charges a “management fee” for his/her services and is typically a percentage on the return of investment made. Also consider, the fund is split into a set number of units. Units can be bought or sold to other investors thereby increasing or decreasing their stake in the fund.

The efficient market hypothesis returns when discussing the criticisms of actively managed mutual funds. As previously mentioned, access to information, expertise and the ability to act quickly on information is the goal of active investors. If an active investor cannot achieve this consistently, they will be beaten by their fellow fund managers who can. This begs the question, how can you find a reliable fund manager? This is a troubling question, especially since, by definition, for a fund manager to outperform the market average, there needs to be another manager who under performs. Furthermore, considerable amount of research indicates active managers rarely are able to consistently outperform the market, indicating that luck plays substantial part in active manager’s performance. This only exacerbates the problem of which fund manager to pick. This isn’t to say there aren’t skilled investors who will consistently beat market returns. The argument is such investors are extremely rare and finding one may take the same level of effort as actively managing your portfolio yourself.

This leads to the second problem of active funds: their management fees. It is only fair that skilled active managers are rewarded for their expertise and time, however paying management fees only makes sense if the returns provided by the manager are consistent and in excess of said fees. If they are not, it may be more prudent to forego the supposed higher returns of an active fund manager and just settle on the average return by owning a cross section of the market.

Exchange Traded Funds (ETFs) therefore are financial securities similar to mutual funds however forego an active manager. ETFs instead track an index (i.e. some measure of the market). For example the S&P 500 ETF is made up of all the stocks for the top 500 largest companies by capitalization in the US. Given an index is easily calculated and the fund can automatically be re-balanced, there is no need for an active fund manager. Hence the lower management fees. Furthermore, ETFs differ from mutual funds as they can be traded as shares on an exchange unlike trading units on a mutual fund provider’s platform.

Problems with ETFs

Any financial instrument you wish to invest in should stand up to scrutiny. It is therefore useful to avoid confirmation bias by considering the following problems with ETFs.

ETF Bubble Argument

Bubbles in financial markets refer to when a the market overprices a specific asset due to irrational demand or popularity. For instance the “dotcom” bubble saw investors evaluating newly founded internet companies to be worth millions more than established companies despite their lack of revenue and clear business model.

ETFs are growing in popularity as a financial instrument for investors and it is this popularity which some fear is causing a bubble. As such, investors speculate that as demand for ETFs increases, so will the demand and hence prices for the underlying stock contained within the ETF. This is an artificial increase as the price of stock changed without any change to the company fundamentals.² Price discovery is a term investors use to describe finding (through research) and correcting (through trading) stock prices to match their intrinsic value. Artificial increases in stock prices without any change in the fundamentals negatively effects price discovery.

In order to address this negative effect on price discovery, an important distinction has to be made between the percentage of ETFs under management and the percentage of ETFs making trades. Even if a large portion of assets owned by investors are passive index funds, this does not mean index funds are responsible for most of the trading between the underlying stocks (i.e. effecting price discovery). The majority of ETFs trades is happening on the secondary market, with ETF investors trading amoungst each other and therefore not directly effecting the underlying stock.³ Anecdotally, this makes sense as ETFs funds are a buy and hold strategy, which are only re-balanced perhaps annually or biannually. Empirically, only 5% of the total market trading is done by ETFs when creating/destroying units. This leaves the rest of the trades to active managers whose research and expertise keep prices reflecting all currently available information.

Although only 5% percent of total market trading is quoted for ETFs, investors should still be cognizant of “closeted index” managers, who although they charge active management fees, they end up replicating some popular index anyway. Thus under representing the true amount of trading done by ETFs. Benjamin Graham, in his book The Intelligent Investor, argues it is within active managers best interest to replicate a total market index, making “closeted” investing a large concern. The following section will describe the nature of the market should most investors switch to passive investing.

Grossman-Stiglitz Paradox and the tipping point

In an efficient market, it is in the best interest of investors to be passively indexing. However, if every investor is indexing, this leads to market inefficiency as no one will be willing to invest the effort for price discovery and hence making the markets less efficient. An inefficient market, leads more active investments to exploit those inefficiencies thus making the market more efficient. This begs the question: At what point should investors switch from active to passive strategies or vice versa?

As previously argued, just the increase in ETFs under management is not enough to trigger this concern.⁴ This tipping point is not limited to the growth of total passive investments under management but is also concerned with the type of active investors left. It is apparent that if most of the investors switching from active to passive investing are unskilled investors, market efficiency remains unchanged.

However, if the most of the investors switching to passive investing are skilled investors, leaving behind mostly unskilled investors, then there is definitely a strong argument for switching back to active investing. Although I haven’t found out when I would be able to tell if this is the case, for now I think it is reasonable to assume other skilled investors will also switch to active investing when it is profitable to do so, hence keeping markets efficient.

“Evil” ETFs

Growth in any area (finance especially), will attract bad players.

High management fee ETFs

ETFs have become a popular investment option for many, given the benefits outlined above. Companies have started offering ETFs tracking exotic or industry specific indexes (e.g. companies in the bio-tech industry or crypto based indices) and charging high management fees given their “exotic-ness.” Always note it is the goal of an ETF is to exploit the mostly efficient stock market by owning a large cross section of all stocks whilst paying minimal fees in the process. An ETF that doesn’t aim to achieve both of these has failed.

Synthetic ETFs

Synthetic ETFs are funds which are built on derivatives. In derivative trading, no underlying asset is exchanging hands. Instead derivatives bet on the outcome of movements by assets. Derivatives introduce substantially more complexity to the simple principles of raising capital discussed earlier. They also introduce a problem of liquidity. Since more money can be tied up to an asset than the value of the asset itself. Hence, synthetic ETFs can inflate market losses as was the case in 2008 with synthetic CDOs (collection of mortgages)⁵. Thankfully, these are not common in US and, at least from what I have seen, in South African markets.

References

All of the information, I have presented is a summary of the following resources.

1. The Index Fund Bubble
2. Setting The Record Straight: Truths about indexing
3. The Index Fund/ETF Bubble - How Bad Is It Really?
4. The Index Fund “Tipping Point”