ETFs get the thumbs-up from traders
Funds' popularity fanned by low management costs and good results. -ST
SINGAPORE - Exchange-traded funds (ETFs) are having a jolly good time of late, with global investments in the product soaring past US$2 trillion (S$2.5 trillion) recently.
The surge followed the remarkable inflow of US$265 billion to ETFs last year, despite challenging market conditions.
It has been quite a ride given that the SPDR Standard & Poor's (S&P) 500 ETF (SPY) - the granddaddy of all ETFs - celebrated its 20th birthday only earlier this month.
The phenomenal growth in ETFs in Asia has been particularly interesting.
Asian ETFs attracted inflows of US$30.6 billion last year, boosting their asset size by 27.1 per cent to US$143.4 billion, and making the region the fastest-growing ETF market in percentage terms.
When the SPY was created in 1993, its aim was to devise a product tracking the S&P 500 Index while trading on an exchange like a stock. It succeeded beyond its creators' wildest imaginations, becoming a US$125 billion behemoth and one of the world's most widely traded securities.
The SPY's success spawned a huge ETF industry, with copycat products mimicking other indexes and assets.
What makes ETFs extremely popular are their low management costs. The SPY, for instance, has an expense ratio of just 0.09 per cent. Yet, by buying into it, an investor gets exposure to 500 of the most widely followed blue chips on Wall Street.
The growing ETF allure is also down to the dismal performance put up by "active" funds that are paid to beat the market.
A report by Bank of America Merrill Lynch suggested that last year only one-third of fund managers outperformed benchmarks in the United States big-cap and small-cap markets.
The global ETF industry has also morphed in other ways - and this may pose risks for unwary investors.
In Europe, banks have created "synthetic" ETFs, which make use of complex financial derivatives to achieve the same results that a traditional ETF does by buying into the assets it is tracking.
In doing so, it has added a layer of counterparty risk: When an investor buys into a synthetic ETF, he is essentially taking a bet against the bank that sells him the product. He loses everything if the ETF provider folds up and cannot pay.
It partly explains why most of the 92 ETFs traded on the Singapore Exchange are designated as "specified investment products".
These require investors who lack the financial know-how or prior trading experience in ETFs to take a test to ascertain their product knowledge before they can buy.
Regulatory concerns aside, the ability of ETFs to outperform active funds in recent years raises the question of whether there is still a role for the traditional stock picking fund manager.
In a recent paper, Mr Matthew Rubin, Neuberger Berman's director of investment strategy, noted that passive investing - as represented by buying into ETFs - is a type of "momentum investing" that allocates resources to the largest and potentially most expensive stocks.
"This is particularly concerning during periods when a few securities dominate a benchmark's return," he said.
Mr Rubin cited the headlong rush into technology companies in the run-up to the bursting of the dot.com bubble in the late 1990s.
"Active managers who were disciplined in buying stocks at reasonable valuations underperformed for a number of years, but subsequently outperformed when the market corrected in 2000," he noted.
Another area where active managers are likely to outperform is in more exotic asset classes, where stock picking is important because indexes are "poor expressions of investment ideas".
"In emerging market equities, for example, the benchmark tends to misrepresent the composition of these economies as commodities and financials typically dominate the index," he said.
Mr Rubin argued that what really matters is the risk an investor is willing to take. If he decides to work with a manager taking less risk, it would only be reasonable for him to expect some underperformance in a higher-return market environment.
Still, whether an investor chooses an actively managed fund over an ETF will depend on whether fund managers can demonstrate convincingly that they are able to spot long-term market trends correctly, and have an ability to pick top-performing stocks. That may prove to be a tall order.
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