Facts Before You Buy An Index Tracking Fund

You’re sick and tired of the finance guys taking your money, underperforming the markets and charging you high fees.

Well, not a problem. A number of financial technology companies have embraced the new age of algorithmic trading and technological wizardry, and have produced an alternative.

Imagine, instead of buying into an actively managed fund that promises you glorious returns and abundant riches, you could buy a single stock for one tenth of the price. This stock will track an index for you, an index which also happens to be one of the ones those same active managers have managed to underperform for the past fifty years. You beat the pros for a fraction of the cost = a job well done.

This is an index tracking exchange-traded fund (ETF).

Extensive research on investment returns shows that active managers have consistently under-performed their benchmarks (the index), and for those who do, the outperformance is swallowed up by investment fees. In the past if you wanted to create an investment portfolio to overcome this inefficiency – and mirror, say, the U.S. stock market (e.g. S&P500) – you would need to buy 500 different companies and weigh them appropriately to match that of the index. This was, and is, an expensive process.

Nowadays an ETF offers complete exposure to an index, with only one purchase on the stock exchange. That same ETF has a face cost of nearly nothing. For example the SPDR S&P500 ETF tracks the largest stock market in the U.S., the S&P500, and costs 0.09%. On the other hand, JPMorgan’s actively managed U.S. Equity fund costs 0.94%.

If you have £100,000 invested the difference is £940 vs. £94.

The convenience of being able to purchase an entire index with one stock, and at typically very low face value costs, is the reason the ETF industry has grown from $250bn in 2003 to $3,500bn today.

It all sounds sunshine and rainbows, right? Despite this, the rise of ETFs do not signal an almighty end to active management.

Here are five reasons why (the last one is important):

  • One concern is that investors do not understand how ETFs work. Some ETFs are leveraged, so that a 5% rise in oil would result in a 10% rise in the ETF, but also vice-versa for a fall. They achieve this through borrowing on the value of the underlying securities, creating quite a risky strategy. The investor may be unaware of this and end up losing more than he/she expects or had originally invested.

 

  • An investor may also be unaware of the structure of the ETF they are buying. Blackrock Gold & General is one of the more popular ETFs on the retail platform Hargreaves & Lansdown, marketed as a tool to gain exposure to Gold. However the ETF does not hold physical gold. At all. Some investors may accidentally find themselves exposed to an ETF of predominantly platinum and copper mining companies, which they assumed tracked Gold. This fund would therefore be unlikely to meet their aims and lead to unexpected market returns.

 

  • The resonation with the financial crisis of 2007/2008. In this case ETFs have achieved the same feat that mortgage backed securities achieved in the 2000s. They have created liquidity in markets that are typically highly illiquid. (NOTE: In financial terms ‘liquidity’ is another way of saying how easy it is to buy or sell something). Take property for example. To buy and sell property through normal channels takes months, however you can buy a property ETF at any hour of the day and sell it minutes later. This liquidity (the ease at which you can buy and sell the ETF) reduces costs (there is a smaller difference on the price a stock is bought and sold at) and heightens market participation.
    • However the idea that you can buy and sell property at the flick of a finger amounts to Wall Street trading, not long term investing. This is not a great mindset for a healthy market, and healthy investment returns. In 2007 the desire to create liquid investments out of highly illiquid mortgage bonds precipitated the financial crisis. In some markets an ETF is no different, for example emerging, property and small cap. If one of these ETFs is unexpectedly and quickly sold off by investors the ETF provider may be unable to offload the underlying assets fast enough.
    • The industry appears to cherish this connection:

“I think of E.T.F.s as technology,” Mr. Wiedman said, as he leaned back in a swivel chair in his office. “It is a product that bundles up a bunch of securities, puts them on a screen and makes them easier to trade.”

I’m not sure what is worse; the quote’s connection to mortgage backed securities, or the fact that Mr Wiedman is the next in line for chief ownership of Blackrock and their $5.4tn (yes, trillion, two times the size of the U.K. economy) of assets under management. At least he didn’t say it is risk free…

 

  • There is also a somewhat philosophical argument that ETFs bring with them a complete breakdown in the entire meaning of market existence. The markets exist to provide a space allowing the movement of capital from inefficient to efficient companies. If a company has poor growth prospects, for example is / has committed fraud (e.g. VW emissions) the market sells their holdings, reducing its price, and uses the money to reinvest in companies with better growth prospects. The markets are built around the votes of confidence from investors. If the market is determined by passive investment then the idea of capital allocation dies. Zombie businesses survive, whilst credible value generating businesses are unable to raise their fair value of investment.

 

  • The last concern is over the transparency of costs. ETFs may have a cheap face cost, for example 0.07% (HSBC American Index) of assets vs. an actively managed 0.97% (Fundsmith Equity), however most investors are unaware of the hidden technicalities that may not turn up in the headline cost. ETFs require constant rebalancing to ensure they continue to track their index, this incurs trading and transaction costs, which will reduce your final return. Furthermore there’s the cost of tracking error. ETFs come close, but in the vast majority of cases, cannot perfectly track an index. You therefore have the cost of investing in a product that doesn’t quite fulfill your requirements. Lastly, as the ETF is traded on the stock market you will need to open a brokerage account, incurring a % of assets under management fee, this could be anywhere from 0.30% to 1% on top of the ETF cost. Then to buy and sell the ETF you will incur trading costs, so if you are paying $12 each time you trade an ETF, a $100 monthly investment creates a 12% cost. Your investment would have to perform exceptionally well to make back those fees. (However, it is worth baring in mind that, on the other hand, a one off investment of $10,000 would turn the 12% trading cost into 0.1%. Size helps.)

My thoughts? ETFs can be a great investment tool and are an exceptional piece of technology. In one particular market – the U.S. equity market – they are almost a necessity for both the retail and institutional investor. The U.S. equity market is the most analysed market in the world, and is therefore operating near market perfection. Active managers painfully struggle to outperform and therefore a long-term holding in an index tracker may be (may be… each client situation is different) the best way to gain U.S. equity exposure. I do, however, also believe that we must not undervalue the expertise of active managers. During times of market turmoil their flexibility and knowledge in actively trading the stocks in their fund may give you a chance of making money, or at least losing less than the market.

During the great depression an adage was used to remind investors of stock market exuberance: “when your hairdresser starts up a conversation with you about stocks it’s time to sell”. I feel the mainstream media’s outspoken objections to active management, and the outstanding growth of ETFs in the past ten years, resonant in this quote.

Your next haircut could cost you more than the usual £20.

-Ed

 

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