In defence of the growth of ETFs

James McManus


3 min read

The ETF industry continues to be a victim of its own success, with exceptional growth followed by criticism from other industry participants. But should investors be worried about the growth in popularity of ETFs?

Image of a wheat up close in a wheat field with the sun behind

The global exchange-traded fund (ETF) market has witnessed significant growth over the past 20 years1, as the products have moved from niche, institutional-only investments, to becoming more common place as retail investments.

So far this year, ETFs have taken in more assets than ever before2, leading some investors to issue a warning cry over their increasing presence in markets. But is this concern warranted?

Perspective matters

The reality is that while the global ETF market has grown, the value invested in ETF products is small in comparison to the total value of the financial markets in which they operate.

Let’s take for example the global equity markets. There is currently £2.71 trillion invested in equity ETFs globally. 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 £38.17 trillion. So, the value of shares held by ETFs globally accounts for just 7.1% of the value of the overall market3.

Bond ETFs own even less of the overall bond market4, 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.

Passive versus active, not ETFs versus the world

In our view, the debate is really about investors moving to passive investment strategies from active management, rather than it being about ETFs (which are just one form of passive investing). We believe that the asset management industry that for so long has benefitted from being able to charge high fees is not happy that their revenues are now declining. There is a real question as to whether managers’ performance justifies their fees.

In fact, the most recent SPIVA scorecards (produced by S&P Dow Jones) showed that, during the five-year period ending 31st December 2016:

  • 88.3% of US large-cap equity managers, 89.95% of US midcap equity managers, and 96.57% of US small-cap equity managers underperformed their respective benchmarks
  • 74.17% of European equity managers underperformed their benchmark (and over ten years to 31st December 2016 this figure rose to 88.25%)
  • 50% of UK equity managers underperformed their benchmark (while over ten years to 31st December 2016 74.19% failed to beat their benchmark)5.

It’s in this context that investors re-allocating capital from active managers to passive approaches such as ETFs should be no surprise.

Should investors be concerned?

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. For example, a large number of investors wishing to sell shares will cause outflows for active managers and other index trackers – as well as ETFs. In our view, the small relative size of the ETF market, and secondary market for ETF shares, means that ETFs have an advantage in this scenario.

That said, we believe that passive investment managers need to recognise that they have growing influence in corporate governance, and they need to start using this influence.

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 ETF providers playing a stronger role in corporate governance.

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. As 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 we make, as we do conceiving the theory behind it. 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 drive improvements, influence product development and resolve structural issues.

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 or future performance indicators are not a reliable indicator of future performance.

Sources

1, 2. ETFGI, 14th August 2017

3. MSCI, 31st July 2017 and Bloomberg, 16th August 2017

4. Bloomberg, 16th August 2017

5. SPIVA® U.S. Scorecard, April 2017 and SPIVA® Europe Scorecard, April 2017

 

James McManus

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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