ETFs

Myth-Busting the “Tyranny of ETFs”

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Kevin Gopaul

Global Head of Exchange Traded Funds

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The exponential growth of exchange traded funds (ETFs) globally has forever changed the world of investing, and it’s only logical for some to question the secular impact. At the extreme, we have research firm Sanford C. Bernstein who claimed in their infamous note to investors, “passive investing is worse than Marxism.”

To dispel this and other misconceptions, Kevin Gopaul, Global Head of ETFs, BMO Global Asset Management, provides clarity on the enduring benefits of indexing, the distinguishing characteristics of ETFs versus indexing, and how passive investing is necessarily pushing active asset managers to deliver outperformance or be rendered obsolete. 

Is the World Over-Indexed?

As indexing, in its various forms, continues to attract a greater portion of investment assets, some critics are worried about the potential impact on market structure and efficient asset pricing.

This view first gained attention in 2016, when a New York research firm named Sanford C. Bernstein declared “passive investing is worse than Marxism.”1 Headlines and panel discussions followed and within two years, concerns about over-indexing had grown to the point where John Bogle, founder and former CEO of the Vanguard Group, said the industry he helped create could bring about a “catastrophe.”

This view first gained notice in 2016,
when a New York research firm named Sanford C. Bernstein declared
“passive investing is worse than Marxism.”

While debating the so-called “tyranny of ETFs” makes for great headlines, and serves as existential fodder for insecure active managers, the facts tell us that there is little to worry about in terms of global over-indexing, as the benefits ETFs continue to promote market liquidity, risk mitigation, lower fees and healthy competition among all asset managers.

Myth #1: ETFs Ignore Price

From a philosophical standpoint, active managers are a driving force in capitalism. Not only do they generate price discovery, by rewarding companies with thriving businesses and good corporate governance, but they also refuse to overpay for stocks whose valuations are stretched to unreasonable limits. While some growth-oriented investors may be satisfied with buying rich and selling richer, value managers are motivated by a desire to find unloved, underpriced securities. ETFs are different, according to critics. Armed with a mandate to track an index, they supposedly undermine the efficient pricing mechanism by buying shares, irrespective of fundamental appeal.

Reality: A glaring flaw in this critique is the conflation of units created and units traded. Once an ETF unit is struck, it trades forever in a market between buyers and sellers. In the ETF world, a unit sold is not necessarily a unit redeemed, which is not the case with individual securities or with pooled funds.  Oft-quoted statistics, including that 25% to 33% of public trading volume represents ETFs, can mislead people into believing passive funds dictate prices. The truth is quite different; less than 2% of ETF trade volume in the U.S. leaves a footprint on the underlying asset prices, something which occurs when units are created or redeemed.

 

 

To better understand these dynamics, contrast ETFs with a situation where you are buying a used car. Whatever is agreed upon in private, it has no bearing on the “lot value” of the car, because no arbitrage opportunity exists to reconcile the two prices.

With indexing, however, market makers are motivated to keep net asset values in sync with one another. So if demand for a technology ETF causes unit creations to rise faster than interest in the underlying asset, a smart trader could simply short the fund and buy its underpinning stocks. It’s the gravitational pull of arbitrage that keeps them in line, ensuring a highly liquid, functional marketplace.

Myth #2: Too Much of a Good Thing

Size appears to be another concern. Some observers claim the market is incapable of withstanding too many index-funds. They also say that scenario is precisely where we’re headed, and it could lead to common ownership of multiple companies in the same niche, because while an active manager would prefer to own one, maybe two, potential winners in each industry as a way of maximizing returns, big ETFs tend to invest in all the major players, making them unwilling or unable to advocate on behalf of their investors.

 

 

Reality: Typically, these criticisms begin with a qualifying statement, such as “if the market was completely indexed,” despite the fact that such a world is purely hypothetical. Moody’s Investor Services estimates that passive market share will only overtake active sometime between 2021 and 2024, and even then, there is no realistic concern of a 100% rotation to index-based funds.  

The fact is some investors will always pursue active management, and by weeding out those who essentially “closet-track” the index, ETFs are in reality keeping active investment managers honest. The two approaches are not mutually exclusive: talented stock-pickers with a record of outperformance should be able to attract funds from sophisticated, knowledgeable investors, and ETFs should be able to provide widespread access to low-cost, diversified investment solutions.  It’s a win/win for investors who are increasingly discovering the benefits of an active/passive mix to both enhance returns and manage risk. 

Indexing versus ETFs

Although the terms “indexing” and “ETFs” are often used interchangeably, they are not synonymous – the former is well understood as passive, benignly mirroring the performance of a major index, but the latter is more versatile, offering customizable exposure to a varied set of investment strategies. 

To be clear, ETFs began as a low-cost capital market efficiency tool. The first of its kind launched in 1990 on the Toronto Stock Exchange, as a single product representing all 35 securities on the TSE-35 Index. Three years later, the introduction of the S&P 500 Trust ETF (SPDR) spurred massive interest in price-efficient diversification, and ultimately propelled the industry to its current, lofty heights. However, the vast majority of new launches today can often diverge from their prescribed benchmark, and are linked to non-traditional indexes, whose ordinal ranking is based on factors other than market capitalization. 

How Should Investors Think About ETFs Rising Popularity?

The rise of smart-beta and multifactor ETFs have utterly transformed the way investors think about indexing, opening up the possibility of seemingly passive products being assembled to build an active portfolio that mitigates risk while also generating higher returns. Issuers have responded to this demand for better asset allocation by creating institutional-quality assets anyone can buy through a regular brokerage account.

Think of them as low-cost portfolio building blocks – making it possible to temporarily over- or under-weight specific asset classes, industries and geographies; hedge against increased market exposure; keep a liquid sleeve to fund redemptions; and build a flexible mix of securities for any environment. The net result: an ETF suite which offers the best features of active management, while keeping the benefits of diversification, low cost and broad accessibility.

That said, it’s important not to simply equate “smart beta” with outperformance, when its true objective is to provide strategic allocation and risk mitigation.

The net result: an ETF suite which offers the best features of active management,
while keeping the benefits of diversification, low cost and broad accessibility.

Although it may be more difficult for ETF providers to express their views to corporate boards, given the complex procedure for drawing down positions from an enormous fund, look for them to be more activist now that Vanguard has started to lever its proxy vote for ESG considerations. Heightened competition for investment dollars will also make it necessary for ETF managers to advocate as strongly as possible in their clients’ best interests, lest redemptions start to chip away at the fund’s profitability.

Ultimately, active and passive are two sides of the same coin, and the competitive pressures driving active managers to innovate will also propel index funds and ETFs to demonstrate consistently high value, for clients and the financial system more broadly.

More Thoughtful Exposure

Whether your priority is income, growth or capital preservation, having specific funds for every situation helps to build a tailored portfolio. The key consideration is flexibility, rather than alpha. For example, for general exposure to Canada’s banking sector, a standard market-cap-weighted index would overweight TD and RBC, given their relative size, whereas the BMO S&P/TSX Equal Weight Banks Index ETF (ZEB) provides the desired diversification across all six big Canadian banks.

For more information on BMO’s award-winning suite of ETFs, or other ideas to enhance your portfolio, please contact your Regional BMO Asset Management Institutional Sales & Service Representative.

For access to industry-leading reports and insights, and monthly ETF trade ideas from our brain trust of investment thought leaders, see the BMO Canadian ETF Dashboard.

1 “The Silent Road to Serfdom: Why Passive Investing is Worse Than Marxism,” Sanford C. Bernstein, August 23, 2016.

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