Why ETFs are only part of the solution

Dominic McCormick explains why exchange-traded funds are a useful tool but not a panacea. 

There has been a lot of media attention lately on the growth in exchange traded funds (ETFs), and as more are launched in Australia, many advisers see them as a panacea for building investment portfolios for their clients supported by asset allocation advice.

Wearied by the global financial crisis, poor returns from some active funds, frozen funds and an increased focus on transparency and costs, ETFs seem to be an attractive proposition.

A recent Russell survey reported that 87 per cent of advisers and brokers would increase their use of ETFs over the next 12 months.

While the additional availability of ETFs is welcome, and I believe they can be very useful tools in asset allocation, they are not the all-encompassing solution some proponents suggest.

Indeed, in the enthusiasm that some commentators and advisers have shown about using ETFs for significant components (or even all) of their client portfolios, a comprehensive assessment of what they do and don’t bring to the table has been neglected.

There are now around 25 ETFs listed in Australia and well over 1,500 ETFs listed worldwide, representing assets of about $US1 trillion.

Most of the Australian funds are effectively versions of existing US listed ETFs, and local liquidity has been relatively poor so far.

However, liquidity will improve over time if there are committed ‘market makers’ in place. Meanwhile, the oldest ETFs offered in Australian such as STW (State Street’s ASX 200) have developed excellent liquidity in recent times.

The key point is that all the locally listed ETFs are passive/index vehicles. While there has been talk of more active ETFs in the US, these have struggled to get traction given the difficulties of implementation.

Therefore, a large part of the case for using ETFs globally is the long running debate between passive and active management.

The active versus passive debate could take several articles by itself to explore and I don’t intend to revisit all the issues here.

Essentially though, the case for passive management is based on a belief that markets are largely efficient and/or it is impossible to identify managers that can take advantages of inefficiencies and outperform from a return versus risk perspective.

Active managers, the argument goes, are not worth the additional cost compared to lower cost passive funds, including ETFs.

The efficient market view of the world has experienced some significant blows in recent years as various bubbles have burst; although this period has also demonstrated that it is certainly not easy to outperform markets (primarily because most active investors are subject to the very behavioural flaws that cause market inefficiencies in the first place).

Nevertheless, while identifying investments and managers that can outperform is not easy, I believe it is possible, and there are a number of well established fund managers (and perhaps more importantly individuals) that have demonstrated this over time.

A less controversial criticism of passive management is that most market indices by nature suffer from some structural flaws that reduce their usefulness in building well diversified portfolios.

Capitalisation weighted indices have a growth bias, as the more expensive stocks (on current earnings) have a greater relative weighting at any point in time.

Studies have shown that portfolios skewed to 'growth' companies have tended to underperform those skewed to value over the long term, especially when adjusted for risk.

Some such indices (and therefore ETFs) are also heavily skewed to a few securities or one or two industries. Is this concentration risk worth taking?

Some suggest that the benchmark index return is the return that all investors should expect as a minimum (less index fees), but they overlook the fact that investment is also about risk as well as return.

The absolute risk of many indexes (and therefore ETFs that are based on them) is often higher than for more active funds in the area (which can consciously avoid such concentration risk).

Of course, active funds have tracking error risk (deviation from the index return), but that is hardly true risk as retail investors define it.

The media’s coverage of ETFs deserves some scrutiny here because it has been implied that ETFs are one of the safest investments available.

On Wednesday 26 May, 2010, the Money section of The Sydney Morning Herald ran an article on ETFs entitled “On a safer track” implying that “battered investors” were turning to ETFs for, among other things, “enhanced security”.

But an ETF investing in Chinese stocks or emerging markets are among the riskiest investments there are.

Even broad based index ETF funds have the same risk as the Australian share market and, after recent years, no one would classify the Australian share market as low risk or appropriate for those looking for ‘enhanced security’.

There have been attempts to rectify some of the structural issues.

Russell recently launched a high dividend ETF that has more of a yield/value bias, but it is still heavily influenced by index weightings.

ETFs work best structurally when they focus on the most liquid stocks, and that is usually those with the highest weightings in indices.

In the US they have gone much further: slicing and dicing the investment universe across styles, sectors and geography, allowing investors to become more diversified, although the job of searching through and building a portfolio from all these ETFs then becomes a highly complex one.

Advisers and investors need to make up their own minds regarding passive versus active investing.

For what it’s worth, State Street believes markets are in for a number of years of extensive range trading (with bouts of high volatility), and overall valuations may average lower levels than in recent decades.

This is not an environment suited to buying and holding passive index exposures, thereby relying on asset allocation alone to deliver on clients’ return objectives.

We are also concerned that the increasing use of passive vehicles (including ETFs) will both increase market inefficiencies and increase the absolute risk of the benchmarks they use.

If instead you believe these concerns are exaggerated, and that Australia can expect a rerun of what it experienced from the 90s through to the mid 2000s, then equity ETFs (and passive investing generally) could work very well.

A lot of the drive to use ETFs is based on cost. Cost is an important issue in investments but it should not be the focus to the exclusion of everything else.

Ultimately, it is after fee returns that matter to investors. Some active managers are worth paying for and the additional costs are often vastly exceeded by the extra return available.

Further, as noted above, cheap index exposures in ETFs may be badly structured from a risk perspective, making well diversified portfolios difficult to create.

Tax efficiency is also a key reason ETFs are promoted strongly.

This tax efficiency results partly from their passive approach, which means there are less realised gains that need to be distributed.

Secondly, the redemption of units by larger shareholders does not generally result in realised tax for remaining unit holders (as occurs with normal unit trusts) because, in taking the underlying shares as the redemption proceeds, they take any capital gains tax liability out with them.

Of course, for those investors who utilise the ability to trade ETFs — often in the short term — these tax benefits are largely irrelevant.

Another key issue is currency. Australian listed ETFs investing offshore are generally unhedged and therefore relatively inflexible, with investors carrying the full currency exposure (although some may prefer this).

One of the key advantages marketed widely is that unlike listed investment companies (LICs), well structured ETFs will trade at or very close to the value of their underlying assets or NTA.

While this gives greater certainty, it also reduces the opportunity to make money from buying LICs at larger than normal discounts or to benefit from a narrowing of discounts over time.

Of course ETFs don’t have to be seen as a buy and hold proposition. Indeed, their ease of trading means that they can be used as a quick and cost effective way to get exposure to an asset class or to change asset class weightings quickly.

Sometimes, rather than spending an enormous amount of time reviewing managers in a particular niche (say Japan), ETFs can provide a quick and easy way to gain exposure, particularly if it is more an asset allocation view and/or a shorter term view.

They can also be used to very quickly add asset allocation exposure without the implementation delays and large buy/sell spreads of some managed funds.

This is the way we have used ETFs at Select very effectively in recent years in our multi-asset, multi-manager portfolios.

But if ETFs are a useful asset allocation tool, the question becomes who is managing this active asset allocation and on what basis.

Dynamic asset allocation done without appropriate experience and discipline is worse than a set and forget approach.

At its worst, history shows that it can become a performance chasing exercise (eg, buying high and selling low) and is likely to be a disaster for investors.

The ease of trading in and out means that ETFs can also become a dangerous tool for some, particularly in the US, where leveraged and short ETFs are prevalent.

We believe a well constructed portfolio is built by first thinking about the investment outlook, including various scenarios/outlooks and market valuations, and then supporting it with a sound overall investment philosophy and approach.

Only then do you look for the appropriate vehicles to implement this view. ETFs are just one such tool that may be used among a very wide universe of options.

On that point, it is worth listing some of the elements that a portfolio only consisting of locally based ETFs will not provide that I believe are important in building well diversified and robust portfolios. These include:

• significant value bias and access to superior long only stock pickers;
• a significant exposure to small/microcap companies;
• exposure to long/short equity strategies;
• exposure to most alternatives assets (eg, private equity, agriculture, etc);
• exposure to alternatives strategies such as managed futures, relative value hedge funds;
• protection strategies such as options or volatility exposure;
• active and/or passive currency hedging;
• an active skew towards particularly attractive themes/sectors within markets;
• exposure to unlisted/less liquid assets such as direct property and infrastructure;
• exposure to discounted listed funds (such as LICs); and
• the full spectrum of fixed interest opportunities.

ETFs can therefore be a useful asset allocation tool for active advisers/investors, but there is much they do not provide for an investor looking to build a well diversified portfolio.

Even for those who believe in a ‘buy and hold’ passive portfolio for the long term, one would question whether they need the additional implementation flexibility of ETFs.

They may well be better off using other passive approaches such as an unlisted index fund (given they don’t need the short-term trading flexibility).

As indicated above, I do have some concerns about whether this passive approach will work well over the next five to 10 years given the investment environment we envisage (of course, we could be wrong).

At the very least, a thorough education of the clients is necessary to convince them of the merits of riding through the large drawdowns and volatility this approach may entail.

However, I doubt whether many of the users (and promoters) of ETFs are focusing on this aspect of investor education. (After all, it is active trading rather than 'buy and hold' investors that will make a particular ETF liquid and therefore successful.)

The removal of commissions is likely to see more use of ETFs, but it is also likely to see LICs and specialist managed funds that don’t pay commission more widely used as well.

In any case, an intelligent investment philosophy and focus on accessing the best opportunities should determine what sensible portfolios look like, not an obsession with low cost funds or those products that makes it easier to charge clients advice fees.

ETFs are a welcome development in the Australian market although their more exuberant supporters are likely to be disappointed.

In our view, it is best to see them as a tool that can help in building sound and flexible portfolios.

Seen instead as the actual means to build largely 'set and forget' portfolios is more likely to result in portfolios that are inflexible and, if our view of the world is right, ultimately flawed. ETFs are likely to be a fascinating focus of debate for years to come.

Dominic McCormick is chief investment officer at Select Asset Management.