[Sponsored Article] Abusing ETFs BHATTACHARYA, Utpal | HACKETHAL, Andreas | LOOS, Benjamin | MEYER, Steffen Review of Finance, 2017, vol 21, 1217-1250 Exchange-traded funds (ETFs) have been one of the most successful product innovations in the finance industry. Among their attractions is the potential to help individual investors attain theoretically-sound portfolios – those that are well-diversified and low-cost. Since the first ETF was launched in 1990, their numbers have mushroomed such that the assets under ETF management today are roughly equivalent to the global hedge fund industry. But does all that translate into actual benefits for investors? Concerns have been reported about how investors abuse such index-linked products and now new research provides clear evidence that ETFs may not improve portfolio performance. Trading data for 6,949 investors attached to a large German brokerage from 2005-2010, revealed that the portfolios of the 1,080 ETF users in the group were no better off than non-users, even after introducing a range of controls and measures. The users themselves – who had traded at least one ETF during the period – were found to be younger, wealthier in terms of both portfolio value and overall wealth, had a shorter relationship with the brokerage, and traded more frequently. But the most important part of the research, which was conducted by Utpal Bhattacharya, Benjamin Loos, Steffen Meyer and Andreas Hackethal, was in showing why ETF users were not benefiting. The authors applied counterfactual analysis to test how the portfolios would have performed under different conditions. First, they compared the performance of portfolios with the ETF portion removed to that when the ETFs were included. The latter performed -1.16 per cent worse than the non-ETF portfolios. Next they looked at timing, comparing what would have happened if the ETFs had been bought and held, rather than bought and sold. The latter activity inflicted damage accounting for -077 percent of the -1.16 per cent differential. The authors also looked at selection and found the average ETF investor would have benefited from following the guidelines of classical finance theory: have a well-diversified, low-cost portfolio. As it was, ETF investors were found to lose -1.69 per cent in net annual portfolio returns by not following this strategy. “The innovation of passive ETFs, with its enormous potential to act as a low-cost and liquid investment vehicle for diversification, may not help individual investors to enhance their portfolio performance. Problems arise when they actively abuse passive ETFs by buying and selling them at the ‘wrong’ time or trading the ‘wrong’ ETFs that are linked to narrow indices. Ironically, the growth in the number of ETFs that track single industries or countries seems to encourage this damaging behaviour,” they said. The authors said their findings should encourage policy-makers, consumer protection agencies, financial planners and others to be more cautious when recommending ETF use. “From a policy perspective, programmes promoting savings in well-diversified, low-cost ETFs that simultaneously limit the potential to actively trade in them, might be beneficial to individual investors,” they added.