RISK AND REWARD
ETFs are a crowd favourite, but there are caveats
Global investors looking to temper prevailing market volatility and remove company- and sector-specific risks increasingly include passive exchange traded fund (ETF) investments in their portfolios.
According to the “BetaShares Global ETF Review”, in the first six months of 2019 US-based ETFs had $56bn in net inflows, versus outflows from traditional managed funds of $8.5bn, while the global ETF industry hit at a record high with $5.6-trillion in assets under management.
Phillip Thuthuka Dube, head of equity finance at Investec, believes this shift is happening because more investors are questioning the performance fees of active fund managers who fail to consistently outperform the market.
“ETFs allow investors to invest directly and at a lower cost, with the potential to receive comparable returns. Spreading investments across shares is also an effective diversification strategy to mitigate risks, and ETFs offer an ideal tool to access a broad spectrum of equities.”
Craig Pheiffer, chief investment strategist at Absa, adds that ETFs also provide access to multiple asset classes, which delivers additional diversification benefits.
“Individual and institutional investors can leverage ETFs to gain offshore exposure or access the bond or listed property markets.”
ETFs also cater to differing investor preferences, risk profiles and levels of investment knowledge and sophistication.
“Some investors may prefer investing in single collective investment schemes, while others might favour a multimanager approach. Some might opt for a segregated portfolio invested directly into individual instruments, but a lack of sector- or asset-specific knowledge or the associated transaction costs can make this approach uneconomical and impractical. It can also be challenging to adequately diversify across an asset class within smaller investment portfolios. ETFs can be useful investment tools in all these instances,” he says.
However, a passive portfolio slant is not a safeguard against volatility. Dube says: “The inherent risk lies in ETF selection. In this regard, selecting providers based solely on total expense ratios and fees can increase portfolio risk.”
Dube highlights a key concern: tracking error. “When investing in multiple low-cost
ETFs, investors must interrogate what each ETF tracks.”
Selecting two or more options that track the same index or have a similar composition would increase concentration risk and water down the diversification benefits. “Conversely, selecting the cheaper fund when comparing options that track the same index is a logical choice because it will outperform the more expensive ETF in real terms. Investors should also select ETFs that align with their risk profile and investment style,” adds Dube.
Keith McLachlan, fund manager at AlphaWealth, agrees that ETFs are elegant and constructive solutions for investors in many instances and markets, but adds that passive investment products don’t work in all markets, all the time.
“An ETF can be beneficial when the market is so large and competitive that active managers cannot realistically expect to consistently outperform it. In these instances, merely tracking the market and keeping costs to a minimum compound growth and generate beautiful beta with little work. The caveat is that full market risks apply.”
In these instances, he says, liquidity also becomes a key issue because ETFs and smart beta are mechanical products that have no discretion.
“Sometimes, active managers are forced buyers or forced sellers of certain stocks, but passive investors are always forced buyers and forced sellers. Any forced buyer or forced seller in an illiquid market where their current and future positions are transparent, like those invested in an index, would be a bad idea because smart investors that have size could merely position themselves ahead of these trades and let the forced trader drive up prices if they were buying, and drive down prices if selling.”
In small, inefficient and illiquid markets, McLachlan says this would be suicide, irrespective of how attractive the underlying index may or may not be.
“Investors therefore need discretion, which they will pay for either in fees, time and research, or in risk and volatility. Ultimately, they will probably have to pay for all of these because finance is a game of trade-offs and discretion is not generally something you want to lose when it comes to passive investing.”
However, Pheiffer believes that the choice between active and passive investing need not be binary. “The two can coexist. It’s all about accessing the wide array of instruments that the market has to offer to achieve the desired investment outcome for each investor, while adopting the appropriate level of individualised investment risk.” ●
Craig Pheiffer … multiple asset classes
Keith McLachlan …not in all markets