Exchange Traded Funds (ETFs) and exchange-traded products (ETPs) are instruments where the value is derived from some underlying asset or product – like indices (shares), commodities, currencies or even interest rates.
ETFs are often marketed as being viable lower cost, lower risk, higher return (due to their purported lower fees) alternatives to investing in actively managed funds.
The overall market for ETFs and ETPs has grown considerably since the Global Financial Crisis in 2008 / 2009 and at the expense of actively managed funds.
The main marketing tool ETF and ETP providers use to market their instruments is their purported low cost nature. Investors and speculators have therefore moved capital en masse into these types of products, unaware of their associated risks and hidden costs.
There are two main types of ETFs. The first is actively managed ETFs. These are ETFs that has a manager or team making decisions on the underlying portfolio allocation. The ETF still has an underlying index, asset or product which it tracks but the manager or team may change sector allocations or deviate from the index as they see fit. The investment returns may therefore differ materially from the underlying index. ‘Smart beta’ products are examples of such products.
The second type of ETF is called a passive ETF. This type of instrument tracks a specific benchmark such as the MSCI All Countries World Index (ACWI).
There are significant risks and hidden costs that are not apparent when investing into active and passive ETFs but significantly more so with passive ETFs.
There are explicit costs and implicit costs involved when investing into ETFs.
Explicit costs are clear and obvious whereas implicit costs are not so obvious. Below you’ll find a comparison between the total costs of a passive ETF and an actively managed fund.
|ETFs/ ETPs||ACTIVELY MANAGED FUND|
|EFFECTIVE ANNUAL CHARGE (EAC)||Investment Management Charge||YES||YES|
|Distribution / Services Fee (advisor & platform)||YES||YES|
|Forced Bid / Ask Spread||YES||NONE|
Table 1: Explicit and Implicit costs associated with investing in ETFs and ETPs relative to an actively managed fund.
From the table above you can clearly see that the fees you pay for your investment in an actively managed fund are solely explicit. What is also clear from the contents of the table is that there are various hidden (implicit) costs involved when investing into ETFs that is not the case with actively managed funds.
For the sake of your time and communicating only the most important facts, I’ve included brief descriptions of each of the costs tabled above.
Effective Annual Charge (EAC)
The latest industry metric in fund manager reporting of fees is called the Effective Annual Charge (EAC), which consists of four components: investment management charge, advice charge, administration charge and ‘other charges’ which include termination charges, penalties and loyalty bonus payments.
Investment Management Charge
Investors should be aware of the management fees that they are being charged by the fund manager. The best metric to establish this is the Total Investment Charge (TIC). The TIC includes transaction costs (brokerage), performance and annual management fees, exchange rate costs, amongst other fees, which the fund management fee does not. It is the most comprehensive fee metric a fund manager can quote.
The TIC of a sizeable ETF like the iShares MSCI World ETF is typically lower than their actively managed counterparts. This is the main fee that ETF product providers will quote to market their product as being “low-cost”.
Distribution / Services Fee
An advisor should always be transparent in the fees they charge their clients. Fintax, for example, charges a flat fee of 0.57% per annum (incl. VAT) on assets under advisement. Both active and passive investments can be administered on an administration platform, which typically charge a flat administration fee based on the quantum of capital invested.
A passive ETF, like the iShares MSCI World ETF, is mandated to track the performance of the MSCI World Index as close as possible. Because it can’t hold all the listed companies in the world, it purchases a representative sample of it.
These holdings continuously rise and fall in price, which suggests that their weighting (attribution) in the underlying index changes. This directly influences the performance of that index.
The result of these movements is that the ETF has to consistently reweight its holdings by selling and buying more or less of each share and can, therefore, never perfectly mimic the performance of the underlying index. There is always an implementation and settlement lag which detracts from the relative performance.
This phenomenon is called ‘tracking error’ and is an implicit cost to the ETF investor. It is a cost because an investor invests in an ETF with the mandate of tracking the performance of the underlying index, which it inherently cannot perfectly do.
Over the short term, the tracking error may not be apparent, but typically becomes exceedingly apparent when longer-term performance is measured. For example, the price of the iShares World Index ETF lags its underlying index by 13bps over the past 5 year period up to 30 June 2017. With specialized ETFs the tracking error may be considerably wider. More on this topic in the ‘performance’ section of this report.
Forced Bid / Ask Spread & Rebalancing Costs
As we’ve now established, due to a passive ETF being mandated to track the performance of the underlying index it must own a representative sample of the constituents of that index – irrespective of their market prices.
When the prices of these shares rise sharply due to positive market sentiment, the ETF has to buy more – regardless of whether the price of the underlying business is in excess of its value. This holds significant investment risk, which I explain later in this article.
When the prices of individual shares are ‘bid up’ in this fashion it aids in the formation of stock market bubbles because it effectively serves as a positive self-reinforcing feedback loop. The more it buys, the more the price of the underlying business increases, the more it has to buy of that business. The ETF is forced to buy the share of the business for whatever price the seller wants to sell the share for.
The same holds true when prices are bid down. In this scenario the ETF may be forced to sell a share for less than an active manager would be willing to in the same scenario. Again, the more it sells, the more the price of the underlying business drops, the more it will have to sell – effectively serving as a negative reinforcing feedback loop. This occurrence is very illogical from the standpoint of a rational investor.
Because a good quality actively managed fund is managed for long-term performance, there is no pressure or time constraints to narrow what a seller of a share is asking for (the ask) and what the investor is willing to pay (the bid). The ETF is, therefore, forced to narrow the bid-ask spread by bidding its purchase price up to meet the seller, not the other way around.
Good quality fund managers can be patient and wait for the prices of good quality businesses to be bid down trade for less than these businesses are intrinsically worth. Shares can be carefully purchased or sold depending on where they trade. Patience is, therefore, a virtue and luxury that the active manager has, whilst the passive ETF does not.
Furthermore, there are no rebalancing fees involved with an unconstrained actively managed fund. The holdings of the fund are solely based on where the fund manager sees value and where their conviction lies. Investor sentiment (greed & fear) – the main detractor from investment performance – is largely taken out of the occasion regarding which holdings to select. Comparatively, in an ETF, it is inherently the primary driver of the underlying holdings.
Warren Buffet famously said: “Be fearful when others are greedy and greedy when others are fearful”. When investing into a market tracking ETF you are inherently fearful when others are and greedy when they are.
In note by Yardeni Research, the implicit costs due to the potential lack in liquidity of ETFs were highlighted by both the UK’s FSB as well as the IMF:
“Separate reports in 2011 by the International Monetary Fund (IMF), the Bank for International Settlement (BIS) and the UK’s Financial Stability Board (FSB) highlighted concerns. The IMF report pointed out: “While most ETFs are supported by one or two market makers, there is no guarantee of active trading under illiquid conditions.” Similarly, the FSB stated: “In principle, ETFs offer on-demand liquidity to investors while they are in some cases based on much less liquid underlying assets. Therefore, in the event of a market sell-off or an unwind in any particular ETF, there is a risk that investors massively demand redemption.” (Source: Yardeni Research, 31 August 2015).”
Even though the iShares MSCI World ETF might have a lower degree of liquidity concerns relative to a more specialized ETF (such as biotechnology) it could have price relative to net asset value (NAV) dislocation influenced by the lack of liquidity. When there is more demand for the ETF than available supply at any one time then the price is bid up in excess of its NAV.
The majority of any passive index ETF’s NAV is based on the aggregate of the market prices of the underlying shares it holds. If the underlying shares are overvalued and the price of the fund’s NAV is in excess of the overvalued underlying aggregate NAV then it is akin to twice overpaying to gain access to the underlying shares. This ‘double premium’ significantly increases your risk as an investor. From table 2 you can see that the NAV of the ETF and its price can be different, even for the largest of ETFs.
|Performance Annualised||1 Year||3Year||5 Year|
|iShares MSCI World NAV||18.38%||5.43%||11.55%|
|iShares MSCI World Price||18.09%||5.40%||11.25%|
Table 2: iShares MSCI World ETF Price and NAV up to 30 June 2017 (latest public fund fact sheet available).
A good quality actively managed fund can outperform the market over the long- term due to the following reasons:
- Undervalued assets can be purchased and managed (i.e be bought and sold as they become more undervalued or overvalued)
- Insight & understanding is required to outperform. It is essential to have the ability to gain insight into individual businesses that are managed by human beings. It requires people to understand the behaviour of other people. Active managers provide this ability.
- Listed shares should not be viewed just as instruments. They are pieces of individual businesses that constantly evolve and can, therefore, rapidly improve or deteriorate. This requires careful analysis.
- During times of market turmoil, some good quality actively managed funds can manage their exposure to any asset class (ie raise cash, increase its fixed income holdings or property exposure, increase its holdings in quality businesses, decrease its holdings in growth holdings etc) – whereas an index does not have this ability.