Why critics of ETFs should be ignored

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he UK, like in many other countries, Exchange Traded Funds (ETFs) are increasingly becoming a threat to old-school fund managers. ETFs, for those not yet familiar with the product, are investment funds that are traded on stock markets – like ordinary shares. But perhaps because of their growing popularity with investors, who enjoy their low cost, they have come in for increasing criticism of late, especially by prominent wealth managers who feel threatened by their rise. The truth is that the so-called dangers of ETFs are in reality less about the actual product, as some would have you believe, but more about their impact on the long-established fund management industry. There have been five principal arguments criticising ETFs – and as we shall see, they all fail to stand up to scrutiny.

1. COUNTERPARTY OR COLLATERAL RISKS
There are two types of ETF in the UK – those that own the underlying constituents of the index, and those where a third party guarantees the index return in exchange for a collection of assets (collateral).

The first kind – physical ETFs – often lend out stocks to ensure that the fund receives some of the associated income. The borrower posts collateral. In such cases, disclosures are indeed terrible as investors do not know how much is lent or the exact collateral deposited. But this is a wealth management industry-wide problem, with many unit trusts also lending out investors’ holdings without full disclosure.

At least in the UK, the maximum counterparty risk for synthetic ETFs – the second kind – is 10 per cent, but in practice many of the largest providers over-collaterise, posting over 100 per cent, and there are strict rules governing what is allowable in this context.

Also, you can see the quality of the collateral as it is often shown daily – one major provider just posts collateral in the form of T-Bills and cash, for example.

2. TRANSPARENCY
This is another common attack but the facts are the exact opposite. An ETF clearly shows which index it tracks and the constituents of the index. Investors can see all of what is held either directly (in physical ETFs) or indirectly in synthetic ETFs. In comparison, the average Investment Management Association (IMA) unit trust has just 40 per cent transparency.

3. LIQUIDITY AND SHORT SELLING
The criticism here is that were an ETF to become huge, compared to its underlying market, it might become illiquid.

Of course this is true, but most of the largest ETFs follow very large liquid indexes and are comparatively small, and the same issue also applies to unit trusts.

If you invest in a large small-company unit trust and everyone wanted to sell, it would probably be impossible and the fund would have to be suspended. At least the ETF would have a dealing price which you might not like but you could accept or reject.

The negative consequences of short selling ETFs are less applicable to the actual holders of ETFs, and cause more of a problem to the person who shorts or lends on the ETF. In fact the more volume there is in an ETF, normally the lower the dealing spread and so the lower the cost for the everyday investors.

4. CHOICE AND NUMBER OF ETFS
This would seem one of the most bizarre attacks. The criticism is based on the growing number of ETFs and assumes this somehow poses huge problems. Is this different from the whole investment industry launching products where they foresee demand?

Investors can either completely bypass the old school investment industry by assembling their own portfolio in an efficient, low cost way, or they can ask an investment professional to pick the best ETFs to suit their investment strategy and risk profile.

ETFs empower the individual as they give them a choice to invest in almost anything and cheaply. As long as each ETF clearly explains what it invests in, it is up to the individual (not the fund managers) to choose what suits.

5. LEVERAGED AND SHORT ETFS
I believe in always looking at the full underlying exposure rather than just the margin. Because these tend to be rebalanced daily, extra risks are clearly explained. Again this is about buyer beware. If someone wants to buy the 2x FTSE 100 ETF, that is their perogative. Some people want such products and as long as it is properly explained to investors exactly how they work, they can make an informed choice.

A SIGNIFICANT INDUSTRY
So what is the real truth behind many of these attacks on the ETF industry? The real danger is actually to the fund management companies rather than investors.

The ETF industry is now becoming significant, not just in terms of its growth but its actual size; and it is making a real impact on the old industry growth and profits.

Over the last 12 months to end March 2011, the UK mutual fund industry has grown by 14.5 per cent – this compares to growth in London listed ETF assets of 31.8 per cent.

UK mutual fund fees are also under pressure, as the following facts reveal:
• The average expense ratio of 2,340 UK unit trusts we analysed was 1.54 per cent.

• The average expense ratio of 987 LSE listed ETFs we analysed was 0.53 per cent.

• The average ETF charges one third of the fees of the average UK unit trust.

This may be the reason several large fund management companies, including JP Morgan and Schroders, are now launching low-cost funds.

UK intermediaries are increasingly cutting-out traditional retail fund managers. They are buying passive lower cost index funds/ETFs either themselves or through a low cost specialist fund manager.

Jupiter, the wealth manager, has already warned this year of the pressure on its margins from more of the cake coming from the independent financial advisers (IFAs) rather than the fund managers.

One of the fastest growing areas in fund management is discretionary portfolios – enabling each investor to have their own set portfolio rather than units in a common fund. Many of these discretionary portfolios use either index or ETF funds.

TRADITIONAL FUNDS UNDERPERFORM
It is clear that investors are waking up to the fact that most traditional fund managers underperform. Statistically, according to iShares, the BlackRock-owned ETF provider, the chance of a manager beating their benchmark three years on the trot is just 4 per cent.

Investors also understandably like transparency, greater liquidity, more diversification, knowing the price before they deal rather than afterwards, paying lower fees, and – more than anything else – being treated with respect.

The reason for the growth of ETFs is that they offer what is unavailable elsewhere. Rather than finding reasons to reject this force for change, traditional fund managers should look to embrace the transparency, liquidity and low fees charged by the ETF industry.

Alan Miller is the chief investment officer and founding partner of SCM Private, and manages Exchange Traded Funds (ETFs).