According to Agnieszka Gehringer and Kai Lehmann, members of the Research Institute of Flossbach von Storch, ETFs go beyond passive investment, due to their hyper trading activity and the latest innovations in the field of smart beta. In this interview with Funds Society, the experts also warn of the uncertain behavior of ETFs in turbulent periods, something not yet tested, and are confident of the industry’s potential for growth in Europe, although, they are aware the stricter rules on the creation of synthetic products could be a drag on its development.
What do you intend when you doubt that ETFs are passive?
The ETF are often put in the context of passive investment, based on the fact that they follow the performance of a certain index. This is exactly the idea staying behind the traditional index funds – an invention of Jack Bogle dating back to 1976. But Bogle aimed at providing an instrument for a long-term investment in stock market by simply following the index. To the contrary, ETF investors are very much short-term focused. They trade ETF shares very actively, indeed hyper-actively. This is what we find in our analysis based on the three biggest equity ETFs tracking respectively the German DAX, the US S&P 500 and the FTSE 100 in the UK. The volume of the ETF shares traded on average every day is four times higher than the traded stocks of the underlying indices. This hyper-activity brings the idea of passive investment ad absurdum.
Has the innovation propagated the creation of ETFs which can be called active? Isn’t it a contradiction? How does the passive and active investing complement one another in an ETF?
Besides the traditional ETF there is indeed a growing interest in the so called smart beta ETFs. Whereas the traditional ETF are supposed to reconstruct 1:1 the index performance based on the market caps of the index constituents, smart beta ETFs weight the basket of the underlying securities based on alternative criteria, called factors. In this way, they aim at performing better than the market and thus better than traditional ETFs. These factors may relate to some kind of assessment of accounting metrics of the index constituents, like book value, dividends, or cash flows, or to still other factors, such as low volatility, undervaluation or expected momentum. In this sense, smart beta ETFs add an active layer with respect to traditional ones: they are not only actively traded, but render the underlying investment choice active as well. Is it a contradiction? I wouldn’t say so – it is more an enhancement on the activity scale. But the important thing to note is that such “active” choices are not comparable with the investment decision made by an active asset manager who thoroughly analyse the entire business model of a company in order to assess its intrinsic value. Smart beta strategies are focused on fast-track, partial, rather than thorough, and more quantitative, rather than qualitative assessment of companies.
Due to this innovation, could ETFs push the active strategies aside?
Given the current popularity of ETFs, be it traditional or smart, it wouldn’t be surprising to see further rise in the relative share of ETF-managed funds. At the same time I would doubt whether it is in the interest of ETF investors to fully eliminate active investment strategy. In the end ETFs freeride on the contribution which active managers deliver to the efficient price building on capital markets. By the same token, we can’t exclude that upon the attainment of a certain critical mass on capital markets by ETFs, the price building process might get into difficulties.
It is often stated that both types of investment strategies would survive. What would be the role played by the one and the other?
It is plausible to expect that both ETFs and active management will coexist. On the side of ETFs, they have been surely attractive so far, given the positive past performance on capital markets and their warranty of obtaining the performance of the underlying index. They could be thus appropriate for investors willing to simply follow the market. At the same time, not much is known so far about ETFs’ performance under difficult weathering conditions on capital markets. Only when markets enter more turbulent waters will we be able to assess the true performance of ETFs. For now ETF investors should keep this uncertainty in mind. On the side of active managers, and especially of those following a consistent and well-founded investment strategy, they will continue to play a role in enhancing the price setting on markets, especially when we see some market turmoil.
In your opinion, which was the major innovation in the world of ETFs during the last years?
The original idea of following the market in order to enjoy the long-term positive return at a rock-bottom cost is quite revolutionary. Their invention may have helped to get in touch with capital markets. But today there is not much left out of this. To the contrary, the hyper-activity of ETF trading and allegedly “smart” investment choices of smart beta ETFs could pose more risks than benefits, should capital markets experience turmoil in the future.
In launching of novelties (smart beta, currency hedging (?), …), where could the next innovations go in the world of ETF?
Given the past creativity in the field of ETFs, the innovation could go anywhere. Just think of the different kinds of thematic or even esoteric ETFs, like for instance “biblically responsible” ETFs… If this trend continues, the question will be increasingly about the risk-reward balance of less diversification and less market liquidity versus chances to pick up an index performing better than the others. All in all, there seem to be less and less well-founded investment choices.
Is the use of ETFs changing – from tactic to strategic positioning? Does this generalization in the use regard all types of investors?
This seems to be particularly the case for institutional investors. In the past, they were using ETF for cash equalization and transition management. But now the growing use for core exposure can be observed.
Comparing the markets, the European with the US market, Europe is lagging behind, but could still catch up. How much could the European industry grow?
The size of the ETF market in Europe is indeed significantly smaller than in the US. Precisely, the total assets held by US-ETFs now add up to about 3.3 bn. USD whereas its European counterparts are currently approaching the roof of 1 bn. USD. There is surely catching up potential for Europe. At the same time, there are some important regulatory changes applying next year, which could decelerate the process. Precisely, rules regarding the creation of the so called synthetic ETFs become more stringent. Accordingly, given the current non-negligible share of synthetic ETFs in Europe, this could have an impact on growth and the speed of convergence between the European and US ETF market.
Could the regulation have an impact on the use of ETFs and why?
As mentioned above, the regulation is already having an impact on the use of – in this specific case synthetic – ETFs. But more generally, given that ETFs can still be considered as relatively new to the financial market reality, the regulators have to gather information and experience regarding the functioning of ETFs. This task is not easy and regulators could lack the necessary information to set up well-functioning rules. And the past teaches us that unfortunately sometimes it needs an external shock to discover the loopholes in the system. Hopefully this time is different.
For Alicia Miguel Serrano
For Fórmate a Fondo