The View

Why the exchange-traded fund industry is a ticking time bomb

History tells us that the kind of market dominance ETFs are enjoying never comes without a fall

PUBLISHED : Wednesday, 29 March, 2017, 9:31am
UPDATED : Wednesday, 29 March, 2017, 11:04pm

Sometimes you have to pinch yourself to remember that just 27 years ago there was no such thing as an exchange-traded fund, or ETF.

By the end of last year these funds collectively had a staggering US$3.55 trillion of assets under management compared with around US$3 trillion in hedge funds, which have been around since 1949 and were long believed to have been the be all and end all in fund management.

Hedge fund assets are shrinking by the day. Last year investors withdrew some US$70 billion, while they poured another US$490 billion into ETFs. Jack Bogle, who founded the Vanguard fund and became one of the leading proponents for low cost, minimally managed funds, has said that these figures “confirm that hedge fund assets will never again exceed those of ETFs”.

Once any form of asset investment management becomes too powerful, the prospect of abuse cannot be ignored

Warren Buffett, arguably the most famous asset manager of our time, placed a bet in 2007 that a Vanguard S&P 500 index fund would beat five hedge funds selected by the investment company Protégé Partners over the next 10 years. He won his US$1 million wager this year, which tells you all you need to know when an active fund manager like him is confident enough to predict that passive investment has a better chance of securing higher returns than the collective genius of those who stock-pick for a living.

So, we are far from done with talking about ETFs because everyday brings new understanding of how, while they are sound investments, they also have the prospect of being increasingly disruptive for the markets.

The US Securities and Exchange Commission is launching a wide scale investigation into the ETF industry because it fears the potential these funds have for exacerbating volatility in financial markets.

Basically the problem is that the sheer volume of their operations and the mechanical way in which they have to adjust to maintain their closeness to various indices means that an aberrant movement in the share price of one or more leading components in any given index can produce an enormous impact elsewhere. To preserve index compatibility, crusty low volume stocks can suddenly spring into high demand for no reason connected to the company’s worth but for every reason connected with index mirroring.

Then there is the increasingly forceful impact that ETFs have on how stock exchange business is conducted. Last year 37 per cent of trading on the New York Stock Exchange occurred in the last 30 minutes of business. Why? Because this is when ETFs have to adjust their holdings to remain in line with the index.

It is only afterwards when the wonderful benefits of hindsight are brought into full play that we learn how obvious it was that there was a problem

Less discussed is the fact that ETF fund companies have to pay the owners of the indices they are tracking for using their name and indeed the indices themselves. The big index compilers, such as S&P and FTSE, make very good money from this business and enhance their monopolistic index services by virtue of their ETF customers. They may therefore be inclined to charge even more and thus eat into the often-voiced claim that ETFs work because of their low management fees. Alternatively this may give rise to opportunistic new indices that are less reflective of the markets they are supposed to reflect. As all indices are far from equal, this could get messy.

But a bigger fear lurks in the background, the fear that should be exercising the minds of everyone in the investment business, which is that once any form of asset investment management becomes too powerful, the prospect of abuse cannot be ignored.

It is way too early to be crying wolf right now because ETFs have been working pretty well for all parties – maybe not for the rest of the fund management business which is losing out, but well for investors and obviously well for the fine folk who have launched these funds. However there is an itch located somewhere at the back of my neck reminding me that the party cannot last forever.

History tells us that this kind of market dominance never, and I mean never, comes without a fall. These falls can be quite dramatic and sudden, leading to the type of carnage that inevitably raises cries of ‘why did no one see this coming?’

Without a crystal ball I am incapable of forecasting when and indeed if such a fall will occur. Maybe someone out there has a much better idea, but you can be pretty sure that while ETFs are riding high forecasters of doom will be ignored. It is only afterwards when the wonderful benefits of hindsight are brought into full play that we learn how obvious it was that there was a problem.

Meanwhile, speaking as an individual investor, I am still pretty keen on ETFs and will remain so until a better idea presents itself.

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

This story was updated to correct the name of Vanguard’s founder