In defence of the growth of ETFs, revisited

James McManus


4 min read

The ETF industry continues to be a victim of its own success, with exceptional growth followed by criticism from other industry participants. Most recently Michael Burry, made famous by the book and later the film The Big Short, has added his name to the list of critics. So, should investors be worried about the growth in popularity of ETFs?

Cube wooden blocks with alphabet to stand for exchange-traded fund, the ETF industry.

The global exchange-traded fund (ETF) market has witnessed phenomenal growth over the past 20 years as the products have moved from niche, institutional-only investments to commonplace investments for investors of all types.

But as the ETF industry continues to attract assets, some investors have issued a warning cry over their increasing presence in markets. Is this concern warranted?

ETFs account for a small chunk of the global market

The reality is that while the global ETF industry has continued to grow, the value invested in ETF products is still relatively small in comparison to the total value of the financial markets in which they operate.

You may have seen headlines recently about the rise of passive equity index funds and ETFs in the US, but the US is something of an outlier. As of 10th September, the total value invested in all equity ETFs globally came to £4.4 trillion1, while stocks included in the MSCI All Country World IMI index (which covers approximately 99% of the global equity market) are currently valued at a combined £42.1 trillion2. So, the value of shares held by ETFs globally accounts for 10.5% of the value of the overall equity market.

Bond ETFs own even less of the overall bond market, in part due to being less established than their equity ETF counterparts, but also because the global bond market remains larger than the global equity market.

In the UK, the share of assets in ETFs is much lower. The total value of equities included in the FTSE All Share Index stands at £2.45 trillion3, while the total value invested in ETFs with a UK equity focus is £19.5 billion globally4, meaning ETFs account for less than 1% of UK equity assets.

Passive versus active, not ETFs versus the world

In our view, the debate is really about investors moving from active to passive investment strategies, rather than about investors moving to ETFs specifically (which are just one form of passive investing).

Clearly, an asset management industry that for so long has benefited from being able to charge high fees for actively managed investments is not happy that their revenues are now declining (passive investments are generally much cheaper than active ones).

However, the evidence is clear: many active managers’ performance doesn’t justify their fees.

In fact, the most recent SPIVA scorecards (produced by S&P Dow Jones)5 showed that, during the five-year period ending 31st December 2018:

  • 82.14% of US large-cap equity managers, 79.88% of US midcap equity managers, and 89.40% of US small-cap equity managers underperformed their respective benchmarks
  • 80.21% of European equity managers failed to beat their benchmark (and over ten years to 31st December 2018 this figure rose to 86.96%)
  • 69.09% of UK equity managers failed to beat their benchmark (while over ten years to 31st December 2018 73.47% failed to beat their benchmark).

In this context, it should be no surprise that investors are reallocating capital from active managers to passive approaches such as ETFs.

Should investors be concerned about the growth of the ETF industry?

As with any rapidly growing market, we feel it’s right that the impact of growth should be questioned and understood.

However, many of the common arguments put forward are not specific to ETFs. As we’ve shown from the relative size of the ETF industry, concerns over a ‘bubble’ in which ETFs drive up the value of the stock market are overplayed, despite recent growth.

So too is the notion that ETFs would frustrate the ability for investors to sell assets in a crisis scenario. In our view, the relatively small size of the ETF market and the secondary market for ETF shares means that ETFs have no disadvantage in this environment. In fact, by allocating their capital relative to size in a given index, the vast majority of index investors are allocating the bulk of their capital to the largest, and often most liquid, securities in any given market.

That said, we do believe that passive investment managers have an increasing influence in areas such as corporate governance, and with that influence comes increased responsibility. Historically, active managers have excelled in maintaining strong corporate governance across the companies in which they decide to invest or lend to, by holding company management accountable to shareholders for their decisions.

As prominent shareholders in ETFs, we’re vocal supporters of better corporate governance and stewardship activities from passive investment managers.

Making the most of ETFs

At Nutmeg, our investment approach is based on the view that asset allocation is key to managing investments. ETFs give our investment team diversification, flexibility, choice, transparency and cost efficiency in managing our customers’ portfolios.

We’ve built our entire ecosystem – from portfolio management to trading infrastructure – specifically with the purpose of maximising the benefits of ETFs.

We dedicate significant resources to research ETFs, which are our primary and preferred tool to implement our investment team’s ideas in client portfolios. We spend just as much time analysing the ‘nuts and bolts’ of individual investments as we do conceiving the theory behind them. Our team continually analyses risks and opportunities within the market and individual strategies to ensure they remain suitable for customer portfolios.

We take an active view in shaping the development of our industry. As keen participants and investors in the ETF market, we recognise our responsibility to make improvements, influence product development and resolve structural issues. We actively engage with other market participants, regulators and product providers from across the industry to shape the future structure of the market and the products that exist within it.

This is an updated version of a blog post that was published on 18 August 2017.

Sources

  1. Bloomberg, Global Equity ETF AUM in GBP, 10/09/2019
  2. MSCI ACWI IMI Factsheet as at 30/08/2019, translated from USD to GBP using Bloomberg fx rate 10/09/2019
  3. Bloomberg, ASX market cap as at 11/09/2019
  4. Bloomberg
  5. https://us.spindices.com/spiva/#/

Risk warning

As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. Past performance is not a reliable indicator of future performance

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James McManus

A self-confessed ETF geek, James is head of ETF research at Nutmeg. He joined in 2015 from Coutts & Co, where he was an associate director in the investment office. James holds a Bsc (Hons) in International Business from Nottingham Business School.


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