ETFs now range from vehicles covering obscure equity market sectors or new “improved” indices to those dealing with a multiplicity of quite different asset classes and categories, including commodities and yield curve exposures.
Is this proliferation a symptom of healthy market expansion, or of excessive complexity and potential market confusion? It is certainly a familiar picture: the eternal rule in the investment industry is that investors want simple products but providers want to sell them complex ones.
This is partly a straightforward consequence of the profit motive. Simple products are subject to intense competition but complex ETFs may not be, certainly not on the same scale. The general principle here is that most competitive markets — whether in investment funds or soapflakes — consolidate into oligopolies and that this process is driven by economies of scale. Alongside the dominant players, nevertheless, big consumer markets can also accommodate clusters of small specialists and beneficiaries of temporary fashions.
In the case of asset management, the economies of scale only work powerfully in the passive sector, that is, in basic index funds. A handful of operators therefore dominate, including BlackRock, Vanguard, State Street and, in the UK institutional sector, Legal & General.
The market structure is quite different in active management, however. The individual size of active funds is limited by liquidity considerations: they can become too big to manage efficiently. Further, marketing pressures can drive fund managers into every highway and byway, fuelled by short-term performance, innovation and investor psychology. Intermediaries, as well as product providers, are constantly trying to “add value” so as to justify their existence. Hence the rise in the past two decades of “boutique” managers and hedge funds, which trade narrowly and charge high fees to clients.
Exchange traded funds are rapidly evolving and are close to reaching the extent of proliferation already seen in the conventional fund area. This expansion has now reached the point where the regulators are becoming concerned. In the US, the Securities and Exchange Commission has launched a review of derivatives-based funds, including ETFs, and for the moment it has suspended the launch of new ETFs with exposures to derivatives, at any rate those registered under the Investment Company Act of 1940.
Meanwhile, in its new document Retail Conduct Risk Outlook, the UK’s Financial Services Authority expresses concern that retail investors may not fully understand the risks of some of the newer, more complex ETFs. The FSA claims to have cranked up its level of supervisory vigilance in this area and threatens to intervene where it perceives a threat to retail investors.
Nobody wants to discourage innovation and flexibility. But considerations of low costs and consistency of long-term strategies have to be observed too. Otherwise the investment management industry will propel its way towards a situation in which there is a vast turnover of assets but the client, on average, underperforms the broad market returns.
Indeed, this is arguably where we have got to. It is partly a question of the old choice between buy-and-hold and churn. It is also about turning attractive, simple concepts such as indices into platforms for endless refocusing and diversification.
In the end it is up to investors to seek value for money. But in the retail sector they are usually too ignorant to make a good job of it. Certainly they are always torn in two opposite directions. That is why the asset management industry is seeing growth at either end of the costs spectrum, in passive funds but also in high-charging hedge funds. If anything it is the middle ground which is being squeezed.
Specialist ETFs may retain some of their virtues as low-cost-vehicles. But the paradox is that they are probably too often being used as the basis for extravagant investment strategies. There are, for instance, so-called dynamic core-satellite approaches and to the extent that they are popular, they will generate demand for ETFs that can allow investment risks to be fine-tuned.
In this market environment there cannot be too many ETFs. But their individual usefulness may well prove short-lived.