Keep ETFs Weird

“Up until not too long ago, anything but the most plain vanilla investment strategies required real effort, technical know-how and moxie. Now all of these strategies are essentially just like stocks. In other words, the ETF ‘normalizes’ exotic investment strategies.” — Joe Weisenthal

It’s easy to forget how revolutionary a product or service is once it has become ubiquitous. A case in point: Apple’s iPhone recently celebrated its 10th anniversary. Can you imagine the world without it?

The same could be said for exchange-traded funds (ETFs). The first ETF, the SPDR S&P 500 Trust, launched 24 years ago, in 1993.

The origin of the first ETF, like that of many innovations, is a bit of a historical fluke. Eric Balchunas recounts how an SEC report on the 1987 stock market crash revealed a loophole that catalyzed the creation of the ETF.

Some argue that the financial industry is not especially adept at creating new, innovative, or valuable products. In fact, when asked what were his favorite financial innovations over the last quarter century, Paul Volcker, former chair of the US Federal Reserve, chose the ATM. Why? Because “It really helps people, it’s useful.”

Based on that criteria, Volcker should have included ETFs on his list. The ETF has been at the forefront of three major investment phenomena over the past two decades, and as a result has had a positive effect on the investment world.

And the ETF space is a viable industry, as assets under management (AUM) have pushed past $4 trillion on a global basis. However, there are three widespread criticisms:

1. Intra-day trading, a critical feature of ETFs, encourages less-than-ideal behavior on the part of investors. This argument is a favorite of Vanguard founder John Bogle. Bogle believes that the turnover seen even in index ETFs puts ETF investors at increased risk as compared to index mutual funds investors. Recent research supports this: Investors have a tendency to “abuse ETFs” through “poor ETF timing” as well as “poor ETF selection,” and would have done better holding low-cost, diversified ETFs.
2. Many ETFs aren’t diversified. Often they are constructed for the sole purpose of capitalizing on a hot market trend. Not only do these funds fail to provide “pure” exposure to the trend, they represent a huge behavioral trap for investors.
3. Returns often don’t match the expectations of the ETF’s title. There is no shortage of candidates in this category, including futures-based commodity funds, leveraged and inverse funds, and funds that track the VIX. The common thread among these products? They are often misunderstood by retail investors and since these individual investors have access to them, established safeguards are effectively bypassed and investor expectations not appropriately managed.

These last two criticisms are a function of the laissez-faire approach that predominated when ETFs came on the market. But the benefits of ETFs result from this relatively relaxed focus. Still, it is not hard to imagine the SEC making it difficult for new and untested ETFs to get listed. But that has not been the case.*

Indexing on the Rise

The first and most significant positive trend sparked by ETFs is the rise of indexing.

Regardless of the measure used, there has been a meaningful shift of assets from actively managed to passive funds. For a long time, Vanguard was the go-to source for index funds. But with the introduction of the ETF, investors with a brokerage account can now access low-cost index funds. Vanguard quickly recognized the importance of the ETF, launching its first in 2001, and is currently the second largest ETF sponsor in the United States.

Other index fund providers understand how critical low costs are to driving the passive investing trend. Charles Schwab, Fidelity, and BlackRock have aggressively cut costs for their index funds to levels comparable to those of existing ETFs. An interesting question: Had they done this sooner, could they have stanched the flow of assets from mutual funds to ETFs?

Beating Home Bias

ETFs have increased the focus on asset allocation among investors and advisers.

These funds make it relatively simple to build a globally diversified portfolio at little to no cost — at most 9 basis points (bps) a year in annual expenses. The ease with which investors can add developed market equities, emerging market equities, or even frontier market equities has helped offset investor “home bias.” By putting additional asset classes on a similar footing to domestic asset classes, ETFs break down these distinctions and allow for more diversified and efficient portfolios.

Smart Beta

In a very real sense, ETFs have become a centralized marketplace for factor or “smart beta” strategies.

The AUM in factor-based ETFs has surged to over $500 billion in the United States. The popularity of low-volatility ETFs has grown. Not long ago, this would have seemed downright weird. As Weisenthal writes:

“. . . the key thing to realize and think about here is that the strategy has been essentially off-limits to most people. How many people, outside of sophisticated traders, would know how to set up a continuous screen for the least-volatile stocks in the market and then turn that screen into a portfolio that continuously rebalances itself? Bear in mind, too, that we’re talking about a portfolio of about 100 stocks.”

Smart beta ETFs have created a real-world horse race for investment factors. There are myriad market anomalies that can be turned into investment products. Unfortunately, most of these factors, especially those that are accounting-based, will likely fail to outperform. But at least the data will be transparent and accessible.

Radical Democratization

Seen in this light, ETFs have, in a very real sense, democratized investing. As Balchunas tweeted:

Last week it was a pot ETF filing, this week the bible. Gotta love the big tent-ness of the ETF industry.. https://t.co/7lGa7v6MF6

— Eric Balchunas (@EricBalchunas) February 28, 2017

No individual and few institutional investors could have conceived or implemented a low-volatility strategy without prohibitive costs. This democratization of investing is the first spillover effect from the introduction and subsequent popularity of ETFs. Once you look beyond traditional index ETFs, there is a whole world of strategies in ETF form.

And not only new strategies, but new players are getting in on the ETF game. Blair Hull, the former blackjack player and early heavyweight in the options market, has launched an ETF that aims to time the market. Blogger Eddy Elfenbein of Crossing Wall Street has rolled out a new ETF that tracks his annual stock picks. This fund is unique both in its fee structure and long-term focus.

While not everyone has an ETF to their name, the field is certainly much more open than ever before.

An Open Field

ETFs have widened the field in other ways. Women are woefully underrepresented in financial services and the investment management industry. In the ETF world, however, the demographics are different. Bethany McLean recently looked at why the ETF industry is more diverse than the rest of investment management. She writes:

“ETFs ‘don’t have this 100-year history of what the people in charge look like,’ says Sue Thompson [a founder of Women in ETFs]. ‘There is more opportunity for the smartest, the brightest, those with the most interesting vision.’”

For a long time, ETFs were an open field. This gave diverse teams, which tend to make better decisions, the freedom to recommend strategies that would have been rejected by more tradition-bound firms.

Robo-Advisers

Investors haven’t always had access to low-cost portfolio management services. The emergence of robo-advisers has thus been a boon to consumers. Robo-advisory services often include portfolio rebalancing, tax-loss harvesting, and, most importantly, asset allocation.

Almost all robo-advisers and the firms that have joined the automated trend use index ETFs to implement their portfolio solutions. The low-cost and inherent tax advantages of ETFs make them perfect for portfolio construction.

As automated advice evolves, it will naturally start to use assets other than those included in ETFs. But ETFs have played an integral role in the automated investment revolution.

ETFs aren’t perfect. Weird stuff can happen when markets are in turmoil. There are many poorly constructed ETFs and some that are downright dangerous in the wrong hands. But that should not dampen enthusiasm for the industry. Low-cost, transparent index ETFs have benefited all kinds of investors.

No one has a monopoly on good ideas. The only way to test whether new strategies are viable is to let them take a shot in the ETF marketplace. The beauty of the ETF industry is its embrace of new ideas and strategies. Tamping down on that would only serve to make the investment world a less interesting place.

So let’s “Keep ETFs Weird.”

If you liked this post, don’t forget to subscribe to the Enterprising Investor.

* This piece was written before the SEC refused to grant an exemption that would have permitted the Winklevoss Bitcoin Trust to begin trading.

All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

 Image credit: ©Getty Images/ the_burtons

Professional Learning for CFA Institute Members

CFA Institute members are empowered to self-determine and self-report professional learning (PL) credits earned, including content on Enterprising Investor. Members can record credits easily using their online PL tracker.