In Focus: Passive Investing  

ETFs offer more than cheap beta

ETFs offer more than cheap beta
 Pexels/Guillaume Meurice

The exchange-traded fund market has enjoyed tremendous growth and currently has more than $9tn (£6.6tn) in assets under management, of which $1.6tn is in Europe. 

Bank of America recently estimated global ETF AUM will reach $50tn by 2050, with the growth coming at the expense of mutual funds, despite their currently having the lion’s share of global AUM.  

So, what are ETFs and why are they so successful?

They are a wrapper to deliver an investment strategy to an investor, which is effectively the same as a mutual fund.

However, the ETF wrapper is an improvement on the mutual fund similar to how mobile phones are an improvement on landlines and electric cars are an improvement on petrol or diesel vehicles. 

One of the major improvements is that ETFs are tradable, so an investor can get 'Amazon Prime' gratification from buying and selling instantly on a stock exchange as opposed to having to complete a form, attach a cheque and wait a week to get a price.

They also tend to be cheaper, with total expense ratios as low as 0.02 per cent annually and rarely above 1 per cent, while mutual fund charges range between 1per cent and 3 per cent.

ETFs are also transparent with regard to the assets they hold and publish this information daily, compared to mutual funds that tend to only disclose holdings monthly, which means the information is out of date, and usually only publish the top 10 holdings.

The first stage of the ETF market has been what is commonly termed as passive. Passive ETFs track well-known indices like FTSE 100, S&P 500 and Eurostoxx 50.

Investors quickly warmed to passive ETFs and used them as core holdings in their portfolios. This adoption meant that investor portfolio costs fell dramatically.

Lower cost portfolios bring massive benefits to long-term investors and saving 1 per cent in fees each year over decades will multiply performance considerably.

Many academics believe that lower fees are the most effective way to grow investments in the long term.

The growth in ETF and passive investing has shone a light on active managers who stock pick rather than use an index to select investments.

They have tended to charge higher fees and on average have underperformed the main indices. This has led to many of the worst performers being weeded out and only the active managers who can demonstrate true alpha surviving. 

The success of ETFs in the passive market has made them hugely popular, but it also means many people conflate passive and ETFs; the reality is that an ETF is just a wrapper.

As a result, ETF investors over the last few years have started demanding more types of investment strategies in ETF form. 

This most notably includes smart beta, thematic, active and niche strategies. I believe that eventually all new funds that have daily liquidity will end up in the ETF wrapper.