Five mainstream criticisms of ETFs, and why you shouldn’t worry

ETFs and Index funds continue to take market share off their actively managed counterparts on an almost one-for-one basis. Active manager warnings grow ever more shrill, ‘a ticking time bomb,’ ‘the cause of the next financial crisis.’ But are they right?

The value of investments can fall as well as rise, and you may get back less than you invested. Past performance is no guarantee of future results
Chessboard

It is right that the more ETFs gain in both popularity and market share, the more examination they deserve to come under. In recent months a number of respected newspaper commentators have become increasingly vocal critics, with regular warnings about some of the perceived risks of investing in ETFs appearing in print.

Here we outline some of the main fears which commentators have, and assess whether their concerns hold up to scrutiny.

1 – ETFs now account for about 30% of all US trading by value - this is dangerous

Huge ETF trading volumes in themselves are of little consequence, as the majority of it is simply buyers and sellers crossing their holdings with the result that there is little-to-no impact on the market. This is because ETF shares are not physically created and redeemed in anything like the volume that their turnover suggests. Using Bloomberg daily data we calculated that in July 2017 the $240 billion SPDR S&P 500 ETF had total turnover of $281 billion, but only $16.9 billion of shares were created and redeemed over the entire month (the net increase in shares outstanding was of 12.3 million shares, or $3.03 billion).

Using this data we can estimate what percentage of Apple’s trading volume was attributable to the SPDR ETF. Apple is 3.9% of SPDR, which suggests SPDR’s turnover of Apple in July was $662 million. Total market turnover of Apple stock was $65.9 billion, making SPDR’s trading impact a princely 1.01%. Yes, there are other large ETFs out there, but it would appear we have nothing to fear quite yet.

2 – ETF investors will get a shock when markets fall, active management will outperform

The theory behind this is that because index funds replicate the index, they have too much exposure to highly valued stocks and will underperform active managers once sentiment turns negative.

The problem with this idea is that, in aggregate, active managers are the market. For every manager that is underweight Vodafone, there is someone else who is overweight. There is little evidence that active funds systematically outperform in a market correction, as they still have the hurdle of fees and trading costs to overcome. Nowadays there are ETFs targeting all sorts of strategies, whether that be equal weighted holdings, value and size tilts, or minimum volatility. These strategies have encroached further into the territory of actively managed funds, and do perform very differently from traditional market cap indices giving investors plenty of choice.

3 – In a liquidity crisis, you don’t want to hold ETFs as there will be no bids for their stocks

It is true that ETFs can give investors an illusion of liquidity, in exactly the same way that a daily pricing fund can. Some asset classes held within ETFs, such as High Yield debt, are illiquid, but this is not a secret to the majority of market participants.

The underlying holdings in an ETF can be no more or less liquid than the market the ETF tracks. If there were no bids, ETFs would trade at discounts to their net asset value and arbitrageurs could make easy profits. However these opportunities are infrequent and ETF pricing is actually very sophisticated, as we outlined here.

In actual fact, we believe actively managed funds face the biggest liquidity threat. This is because securities which are held in indices have a much larger audience - both mainstream and also held in size by ETF market makers. In times of crisis, it is the holdings which are ‘off-index’ which can literally have no bids for them when there is a forced seller and liquidity dries up. This causes prices to gap down by a large amount, and is one of the reasons that small caps always perform worse than large caps in a sustained sell-off.

We saw this with the Third Avenue Focused Credit Fund at the tail end of 2015. This fund held very illiquid high yield bonds, and when the market rolled over there was no market for their holdings. Redemptions were suspended, and investors locked in. High yield ETF investors did face this problem.

4 – Index trackers break basic rules of prudent portfolio management

UCITS funds, which are regulated in Europe, have rules over how much concentration they can have. No holdings can be over 10% of a fund, and those securities between 5% and 10% cannot add up to more than 40% of the portfolio (the ‘5/40 rule’). This is designed to protect investors from the credit risk of individual companies going bankrupt.

ETFs are exempt from this, and with hundreds of different indices to choose from, there are many cases of index products having concentrated holdings. For example, MSCI Korea has a 27% exposure to Samsung, while the NASDAQ 100 index has slightly over 40% allocated to Facebook, Amazon, Apple, Microsoft and Google.

Does this matter? We would say not. Individual ETFs are not designed to be the only position that you hold, while an advisor could justifiably recommend holding just one fund (which may only publish the top 10 holdings on a monthly basis). In any case, holding a concentrated ETF is still a much more effective way of getting exposure to a segment of the market than buying just one stock.

Ultimately asset allocation will drive your portfolio performance, and ETFs are an excellent way to get huge amounts of diversification at a very low cost. Using a cooking analogy, if ETFs are the ingredients, the skill is still in how you blend them together.  Find out how IG Smart Portfolios could help your investment goals.

5 – Index funds make the market less efficient

This theory is a very long way from being true. On the one hand removing lots of unskilled individual investors from the market should mean than there is less alpha to go around for professional investors, thereby making it harder to outperform the market. On the other, it is possible that if index funds dominated equity flows then they could have an impact on how the market prices individual securities. As shown with the example of Apple’s monthly turnover, we believe the equity markets are a very long way from this point. In any case, the performance of active fund managers still shows no sign of improvement.

You can buy ETFs on IG’s share dealing platform from just £5. Our ETF screener is a great tool to search for your favoured markets.

An investor should always read the ETF prospectus or Key Investor Document (KIID) before investing.

This information has been prepared by IG, a trading name of IG Markets Limited. In addition to the disclaimer below, the material on this page does not contain a record of our trading prices, or an offer of, or solicitation for, a transaction in any financial instrument. IG accepts no responsibility for any use that may be made of these comments and for any consequences that result. No representation or warranty is given as to the accuracy or completeness of this information. Consequently any person acting on it does so entirely at their own risk. Any research provided does not have regard to the specific investment objectives, financial situation and needs of any specific person who may receive it. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such is considered to be a marketing communication. Although we are not specifically constrained from dealing ahead of our recommendations we do not seek to take advantage of them before they are provided to our clients. See full non-independent research disclaimer and quarterly summary.

Open an account now