The View

ETFs -- the best vehicle for small investors

Hong Kong’s MPF still refuses to allow members to invest in ETFs and funnels them to expensive funds

PUBLISHED : Wednesday, 30 December, 2015, 11:14am
UPDATED : Wednesday, 30 December, 2015, 11:14am

At the dawn of the New Year it seems appropriate to look again at the most successful investment vehicle for smaller investors, and one that is increasingly used by much larger institutions who have belatedly conceded that their active investment policies are consistently outperformed by doing nothing other than sitting back and tracking indices with exchange traded funds or ETFs.

In 2003 there were a mere 151 ETFs in the investment universe and they had assets totaling US$151 billion. By 2014, the number of ETFs had risen to 1,974 with assets of $2.7 trillion. Unconfirmed figures for this year suggest that the asset level is now well in excess of $3 trillion.

The reason why these funds have mushroomed is not hard to find. By any measure ETFs deliver far better returns than managed funds and in terms of total returns, i.e. returns that take account of the costs of investment and indicate the real profits made by investors, tracker funds have a consistent record of beating managed funds to a pulp.

The much quoted figure for the performance of actively managed funds is that only 20 per cent are able to beat the indices within which they operate. That means that tracker funds will outperform them 8 out of 10 times.

So, the case for ETFs remains strong and what I find surprising is not the phenomenal growth of this type of investment but the lingering optimism of otherwise sensible investors who continue to place their trust in active fund managers promising to outperform the indexes. This is a classic example of hope over experience.

That said the ETF picture is becoming increasingly complex. Some index trackers end the year outperforming their indices while others fall short. The reasons are complex because while the objective of ETF managers is to optimize tracking in any given market, the way they do it involves buying shares or other investment instruments on both a long and short term basis, this sometimes means hedging and using other methods to literally keep them on track.

The sheer volume of index trading makes it more difficult to keep up with market movements. That volume has now been greatly increased by active fund managers resorting to tracking techniques. A recent study by four prominent academics in Europe and the US found that a growing number of these funds were miss-selling their products because they were in reality largely dependent on tracking activity.

In Canada, Finland and Spain, some 40 per cent of the investments made by alleged active managers were in fact index-hugging investments. In Sweden and Poland that percentage rose above 50 per cent. Overall the study found that in the 20 countries they examined so called ‘closet tracking’ was prevalent and accounted for over 50 per cent of their investments.

The sting in the tail is that despite being passive investors these fund managers continue to charge active manager type fees.

And here’s the rub because one of the attractions of ETFs is the low cost of management. ETF management fees average out at 0.59 per cent compared with 1.4 per cent for actively managed funds, which also have the habit of adding other management costs. Meanwhile in the US two of the largest ETF providers, BlackRock and Charles Schwarb, are engaged in a fees price war that, lamentably, has not reached Hong Kong.

Another complexity in the ETF picture is the growing number of funds offering investments in sub-indices, commodities is the most popular. The tracking principle remains untouched but it involves investors making bigger decisions than are implied by the simple expedient of investing in a fund that covers the entire market.

America remains the ETF heartland, accounting for 73 per cent of tracker funds’ global business, compared to a mere 8 per cent share for Africa and the Asia-Pacific region combined. Moreover American companies run most of the biggest ETFs operating here and elsewhere in Asia.

Meanwhile here in Hong Kong we benefit from the existence of the Tracker Fund, one of the few state run ETFs. It is very low cost and does an admirable job of tracking the local market. The scandal is that since inception and despite changes to its structure and scope of providers the Mandatory Provident Fund still does not allow MPF members to put their money into ETFs and insists that their investments go to higher cost, lower performing active fund managers.

ETFs are, of course, boring and allegedly savvy market players are quite sniffy about them, yet the more I come into contact to with market professionals the more I discover that despite disparaging ETFs in public they increasingly turn to them for their own investments. So by all means listen to what they say but follow the money trail for a better insight.

Stephen Vines runs companies in the food sector and moonlights as a journalist and a broadcaster