Exchange-traded products (ETPs), baskets of securities that track an underlying index, have undergone exponential growth in popularity both locally and internationally recently. Yet arguments about how well they work are raging.

According to investment website Investopedia, exchange-traded funds (EFTs) grew from one fund in 1993 to 102 funds in 2002 and nearly 1,000 by the end of 2009. Now, “According to research firm ETFGI, there are now at least 5,000 ETFs trading globally, with more than 1,750 based in the US. If you include exchange-traded notes, a much smaller category, there is an additional 1,900 globally.”

The reason behind the surge, Reuters reports, “is that it isn’t possible for investors to beat the market benchmark over time, so you might as well just own the whole market benchmark for all of time and space, reap market-like returns, and enjoy life. Simple, cheap and – in practice – hard to do.”

Despite their recent surge in worldwide popularity, ETFs still represent a small percentage of the South African investment universe, perhaps making exaggerated warnings about their potential impact somewhat redundant – especially as unit trusts invest in many of the same assets.

At the end of June 2019, the total market capitalisation of all listed ETPs in South Africa was R91.3-billion, according to ETFSA, an organisation that promotes ETFs. That is a substantial increase from the market capitalisation of R77.8-billion at the end of 2018, a rise of 17.4%.

“That is only around 7% (including passive unit trusts) of the investment universe in South Africa,” says Gareth Stobie, managing director of CoreShares, a local passive investment management business.

ETFs can be a great investment vehicle for small and large investors alike and have become a popular choice for portfolios looking for diversity at a lower cost with the least amount of effort.

Ben Volkwyn, head of private clients at Cannon, says that, in contrast to stocks, the number of outstanding shares in an ETF can change daily owing to the continuous creation and redemption of shares by authorised participants.

“Effectively this means that ETF structures derive their liquidity from their underlying assets, carrying the same liquidity risks as the underlying portfolio – which should be understood and considered before investing,” he adds.

Volkwyn further cautions investors on very thinly traded ETFs, which have cost implications. And other discrepancies may occur.

“Indeed, these very discrepancies have led some to claim that ETFs may, in fact, boost market liquidity, as authorised participants profit by trading on price differences between ETFs and their underlying assets.”

Dean de Nysschen, a research and investment analyst at Sanlam’s Glacier, says in an editorial that it is probable developed markets such as the US are more efficient when it comes to pricing. In other words, the prices of the shares have taken into account all factors, present and future, that may affect the price of that share.

“Some believe this pricing mechanism to be less efficient in developing markets, such as South Africa, hence the tendency to stick with actively managed funds where managers are able to take advantage of any opportunities presented by the market,” says De Nysschen.

But Stobie says the price inefficiencies are greatly overstated, explaining that ETFs, like passive unit trusts, will experience volatility in line with market movements, just like the underlying shares or indices in tracks, and, as with traditional funds, investors need to be patient for the long haul to experience real growth benefits.

The bubble implied by critics in the asset class including index trackers can more accurately be described as the overdue deflation of active management bubble, despite reams of evidence that most active money managers underperform the market after fees, he says.

The reality is sinking in, and it’s only natural that the shift of money from traditional strategies to cheaper index-mimicking ones have active managers calling foul, says Stobie.

“The sky is not falling,” he says. “It’s rather large volumes being driven through various types of index products than a failure in traditional market forces that are at play here,” he says.

“Questions have been raised about the instant liquidity promised by ETFs and the underlying liquidity of some of their securities, especially at a time when trading conditions of many markets seem to have deteriorated. Yet there have been several major tests of the mechanics of ETFs in recent years, without any major mishaps,” writes the UK’s Financial Times.

“The argument that index funds make equity markets less efficient is not factually true, it is actually having the opposite impact,” notes Stobie. “It is driving out expensive and poor-performing fund managers.”

He does, however, add that the new power brokers of the corporate world might have a negative impact on governance practices, as activist and institutional investors keep company board members and their executives on their toes.

The FT points to former hedge fund manager Michael Burry (one of the main characters in the movie The Big Short) and his more nuanced view “that the rising importance of index funds means that smaller companies that haven’t made it into one of the more popular benchmarks are unfairly shunned — is valid”.

“Although the valuation gap between indexed heaven and below-benchmark hell is widening, likely due to index funds, this surely just means richer opportunities for money managers to exploit,” says the newspaper.

Stobie agrees with this point.

De Nysschen further warns that, due to the increasing number of ETFs available, as well as the introduction of smart-beta funds that aim to outperform the index, investors still need to consider carefully which index option is best aligned with their needs and goals.

Investors can combine ETFs with actively managed funds for optimal performance across their overall portfolio.

While one of the main benefits of an ETF is its lower cost structure compared to actively managed unit trust investments, he advises in an editorial that investors should buy ETFs when they show value, and not only buy blindly due to their low-cost structure. BM