In Focus: Passive Investing  

All you wanted to know about ETFs (but were afraid to ask)

  • To be able to explain the spectrum of passive funds.
  • To know more about the development of exchange-traded funds.
  • To have a better knowledge of what is driving innovation.
All you wanted to know about ETFs (but were afraid to ask)
Photo: MayoFi via Pexels

Investors wanting to get their hands on more esoteric investments without taking on too much direct exposure risk have been turning to exchange-traded funds and smart beta strategies to do so.

Over the past few years, more passive strategies have been created and employed to allow investors to track a basket of cryptocurrencies, for example, or to get exposure to less liquid infrastructure projects. 

There are even ETFs available for people who want to invest in cannabis production for medical purposes (which could be lucrative if Mary Jane becomes decriminalised), or if music streaming's your client's thing, then the Ark W ETF might hit the right note with them.

Things certainly have changed since Wells Fargo launched the forerunner to the ETF 50 years ago; assets under management are rising year on year, and the ETF sector globally is worth $9tn and counting. As the graph below shows, money is flowing into the sector.

But as ETFs and smart beta-style passive investments become more prevalent and more popular, have investors (or product developers) lost sight of the original reason for tracker funds?

Is there such a thing as too much innovation? And does the old conventional wisdom of starting out on your investment journey with a tracker fund still hold true?

Reasons for popularity

For many investors, the low-cost argument of passive funds is hard to beat. After all, Berkshire Hathaway founder Warren Buffett once said everyone should start off with an S&P 500 fund. 

Does this mantra still hold true?

According to Tom Bailey, ETFs specialist for consumer platform Interactive Investor, the simple answer is "yes". 

He says: "If we take this famous statement from Buffett to mean a general encouragement of investors to buy low-cost passive funds, I’d say the wisdom still holds true.

"Most data shows that most fund managers fail to beat a comparable broad basket index over time."

Yet Bailey qualifies his assertion: "The specific mention of an S&P 500 tracker is probably less sage advice. The S&P 500 is a US company index. So just investing in an S&P 500 index would give the investor just exposure to US large caps.

"That would have actually been a rewarding weighting over the past decade, owing to outperformance of US large-cap stocks."

He says investors should ask whether that continues to be a winning exposure. "Who knows? But it is probably best that indexed passive investors have a more globally diversified portfolio."

So he says the usefulness of that Buffett quote is in the broad endorsement of low-cost index fund-style investing rather than his mention of a specific index. 

Tim Morris, adviser at Russell & Co, often uses ETFs in client portfolios. He comments: "Increasing use of passives has massively helped drive down the costs of investing in recent years."

Kenneth Lamont, senior analyst of passive strategies, manager research at Morningstar, agrees cost plays a big part. 

He says: "Our own research has shown that fees are the most reliable predictor of future fund returns (lower fee predicts higher returns).