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.
  • 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.
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All you wanted to know about ETFs (but were afraid to ask)
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This means that, unlike a classic passive fund that is constrained by its index, investors can be more selective about how they invest and perhaps avoid some of the high sector weightings in areas that a client might not want to invest in, such as oil and gas, or mining. 

According to Bailey, early academic research was largely based on the CRSP database of US stocks – a database of US stock market historic prices and returns – founded in 1960. Such a comprehensive amount of data on US stock prices and returns had never been available before.

Bailey says: "It opened up a lot of potential for research into stock prices. One outcome was academics uncovering that stocks with certain financial characteristics (such as low beta, value, small cap or momentum) provided outperformance over certain periods.

"The big breakthrough came with the French-Fama three-factor model paper in the early 1990s. This eventually resulted in fund houses launching products that tracked stocks with common financial characteristics, often called factors."

Increasing complication

But with increased flexibility also comes increased complication, and ETFs have become ever-more tailored, almost to the point of being extremely selective.

So how did trackers become so complicated? Why do advisers now find themselves explaining concepts such as ESG overlays, smart beta or managed trackers to their clients?

Lamont says the best way to think about funds is to "imagine a spectrum".

He explains: "On one end you have dyed-in-the-wool stock pickers (something close to pure active) and on the other a global tracker fund, which makes no bets against the market (close to pure passive).

"Most new index funds or ETF launches now sit somewhere in between those poles."

This means the benefits of passive funds – transparency and low cost – can be "meshed" with traditional active strategies, he says.

"Because they track a set of investment rules (codified in an index) investors can see what an index fund or ETF holds daily and understand why it is held, which also holds true of more complex indexed strategies.

"Because you are not paying an active manager, even with more complex indexed strategies, this means active bets against the market can be offered at a much cheaper rate."

It is important to remember that an ETF is just a wrapper – albeit a very innovative one.Bailey

The immense amount of data on historic stock prices (beyond just the CRSP) has meant researchers and others have been able to study the historic returns of stocks much better, and slice the data in different ways.

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