Last Updated: 18 January 2023
As a rallying cry, “asset managers are taking small and well-controlled risks to achieve solid but unexciting rewards” doesn’t have the same ring as “put the cat back in the bag” or, dare I say, ”the sky is falling!” For passive investment managers, hyperbole comes hard. It just doesn’t feature in the job description. So we will leave the headline writing to others, but it doesn’t mean we don’t feel strongly. Indeed, in our view the current “debate” around ETFs is overweight conclusions and underweight facts and analysis. Here are a few thoughts that attempt to redress the imbalance.
First, exchange-traded funds work. The ETF industry has an unparalleled record in delivering on its performance promises: efficient benchmark tracking, relatively low cost, high transparency and improved liquidity when compared with conventional funds. For more than 20 years, these products have delivered on their promises. This is equally true, regardless of whether the funds are physical or synthetic, or whether they engage in securities lending or not. (I would concede that some optimised physical funds have struggled with tracking error on occasion, but there’s nothing here that would warrant the deep and sustained attention of regulators or the media). In particular, the approach of the ETF industry to transparency puts most other investment products to shame.
Second, taking counterparty risk is not dumb. ETFs take relatively small risks in order to improve the effectiveness of their benchmark tracking. Some funds engage in securities lending to generate supplemental revenue to make up for other sources of tracking error. So-called “synthetic” ETFs use swap contracts to lock in a specific level of benchmark performance. Both types of fund rely on counterparty performance. Both use broadly accepted and effective risk mitigation techniques to reduce the potential for loss. Indeed, the ETF industry has used these techniques since its inception with increasing effectiveness and, to our knowledge, no material adverse consequence.
A useful analogy is property ownership. If you purchase a property for investment you can choose whether to rent it out or leave it empty. If you take on a tenant, you incur risk: they may not pay the rent, they might stain the carpet, they might invite the local chapter of “squatters anonymous” to stay for the weekend. You can avoid these risks by keeping the property empty. But then you forgo the rent. You can mitigate your risk by conducting background checks, insisting on references and a salary history and inspecting the property on a regular basis, but it will not go away completely. Is it inherently stupid to become a landlord? No. But neither is it simple. However, the simple approach (no tenants, no rent) is unlikely to be the wise choice.
Third, life is relative. ETF providers did not invent derivatives, counterparty risk, securities lending or even “swap-backed” funds. Indeed, in Europe there are €6 trillion of assets in UCITS funds and nearly half of these assets (approximately €2.8 trillion) are currently available for securities lending. By contrast, the assets under management of the entire European ETF industry are less than €250 billion. In other words, there are ten times more assets sitting in UCITS funds that are available for securities lending than are managed by the whole of the ETF industry!
So why is this debate about ETFs? Perhaps it is because they are transparent. Perhaps it is because ETF issuers talk to their clients (endlessly and boringly) about their structures. Perhaps it is because we criticise one another and compete on the basis of continuously improving risk management techniques. Regardless, while it is important and appropriate that investors understand how ETFs operate, it is also important and appropriate that they have a comparable understanding of their investment alternatives.
On any meaningful measure (cost, performance, transparency, liquidity, structural risk), any objective evaluation would award high marks to ETFs. Compared to conventional funds, ETFs offer greater transparency, a higher certainty of performance, improved liquidity, lower fees and, typically, comparable levels of counterparty risk. Compared to structured notes, they offer substantially reduced counterparty risk, simplicity of investment thesis and lower fees. Compared to cash accounts and government bonds, they offer the potential for future appreciation in a world of historically low interest rates.
Investing is not easy. Complexity and safety are not antithetical. Nor are simplicity and safety synonymous.