ETFs great but free ride will catch up with the market
Ilike to invest in exchangetraded funds (ETFs). The fees are cheaper than actively managed funds, and they are convenient and give you access to welldiversified portfolios.
They are also available within tax-free savings accounts you can open with stockbrokers, giving you the only way possible to avoid every tax levied on trading in equities. You get global exposure without exchange control hassle. It is a no-brainer, even in taxable accounts.
But that doesn’t mean ETFs are good in every sense. And as their popularity grows worldwide, I expect we will come to recognise this more clearly. This month, according to data from consultancy ETFGI, worldwide ETF assets reached R60-trillion after R1.2-trillion of additional inflows in January 2018 alone.
It is nearly impossible to calculate what proportion of global investment that represents, because funds can now hold a bewildering variety of assets, including synthetic instruments and commodities. According to investment advisers Willis Towers Watson, the assets held by the 500 largest fund managers worldwide add up to almost R1,000-trillion (known as a quadrillion). Worldwide ETF assets represent 6% of that, though Willis Towers Watson estimates that 22% of assets held by the 500 largest managers are passively managed.
ETFGI estimates that over the past 10 years ETF assets have grown by a compound annual average of 18.9%. In SA the trend is similar. There are now 86 listed ETFs and exchange-traded notes, a simi- lar kind of instrument. Collectively they hold R70bn, though almost half is held by the top three funds alone: NewGold (R15.3bn), NewPlat (R10bn) and the Satrix 40 (R7.6bn).
Assets have grown from R20bn in 2009, a compound growth rate of 17%, not far off the international trend.
As is clear from the top three, not all ETFs are invested in shares. Several invest in commodities, currencies or property. But ETFs are at the leading edge of the passive investment revolution. They are complemented by many other passively managed funds that are registered as other types of funds, including collective investment schemes. These don’t make active investment decisions — they simply track an index of stocks, holding the shares in that index according to a predetermined formula.
ETFs are only 25 years old, with the first listed in the US in 1993 and the first listed in SA 17 years ago. They are the consequence of several theories in finance that demonstrate that active stock picking does not deliver above-average returns. You are better off investing in a broad portfolio of stocks rather than trying to consistently pick winning stocks. Active investing, according to the theory, doesn’t work on average and it costs money. So don’t waste fees.
The problem with the theory is that it is obviously wrong in a certain sense. Markets need price discovery. That means they need active decision makers deciding whether to buy or sell and at what price. While we may not look at the price of a loaf of bread every time we go into Pick ‘n Pay, we are confident that it is fairly priced because, on average, enough people do look at the price and make buying decisions accordingly.
Investing in an ETF is like going into Pick n Pay blindfolded. You’ll probably end up no worse off, but that’s only because of all the other customers who ensure supply and demand keep Pick n Pay’s prices reasonable. If every customer was blindfolded, prices would lose their anchor.
In the same way, too large a proportion of passive investing will cause market prices to become inefficient and to lose their relationship with the true value of a stock. If everyone was blindfolded, markets would stop working. So the theory depends on a large active market.
We sometimes lose sight of the basic motivations for a stock market. Equity investors want liquidity, which is the ability to sell or buy the equity in companies. When they choose to buy the shares of a company it is because they believe it offers the prospect of reasonable returns for the risk. At some price it does not, while at another price it does. The market is an aggregating device that allows for everyone’s views to settle on some equilibrium which forms the market price.
Passive investors then take a free ride on those prices that are bound up into an index.
Usually, passive funds lag the index — this is known as tracking error — because they always hold a small amount of cash and have to pay trading fees. But what’s less visible is the cost to overall market efficiency of a decline in active decision making. While passive investing is still relatively small, this cost won’t be much.
But at some point in future, given the trends, the point will be reached when the cost of passive investing is too large for the rest of the market to bear. When that day comes the logical way to deal with it would be to charge passive funds a fee or tax that covers the cost of active decision makers, or makes them more competitive.
I imagine that will take an almighty fight. For now, though, ETFs remain a no-brainer.
You can put R33,000 a year into them tax-free, and the current tax year expires at the end of February.
YOU ARE BETTER OFF IN A BROAD PORTFOLIO ... RATHER THAN TRYING TO CONSISTENTLY PICK WINNING STOCKS THE POINT WILL BE REACHED WHEN THE COST OF PASSIVE INVESTING IS TOO LARGE FOR THE ... MARKET TO BEAR