Analysis: Are criticisms of ETFs justified?

ETFsPassive funds have come under attack as having the potential to cause the next market crash due to their structure and the way they are managed.

Baillie Gifford partner and fund manager Charles Plowden has recently condemned  ETFs as “dumb money” and compared them with the complex packaged trading instruments – such as collateralised debt obligations – that were missold before the crisis 10 years ago.

Plowden, who manages one of Baillie Gifford’s flagship funds, the £1.5bn Monks investment trust, said investors are blindly buying ETFs without knowing what they contain.

Vanguard, one of the largest providers of passive funds, is Baillie Gifford’s largest client.

Fund Strategy has spoken to passive managers to see how they run their funds and asked commentators whether the fears around ETFs are justified.

Plowden said ETFs resemble collateralised debt obligations, which were sold to people as a safe investment without explaining what they contained.

He said: “There’s no interest [in what is in an ETF] because things are going to be there for only three months. Some ETFs turn over once a week. Investors don’t have time to be interested in the companies they are in. We tend to think of these index funds as dumb money; they are non-thinking money.”

Seven Investment Management senior investment management Peter Sleep argues ETFs can be far more transparent than other type of funds as they disclose daily their index methodology as well as their holdings on their websites.

Sleep says: “Even the rapidly diminishing synthetic ETFs will disclose the index they track and any collateral that they hold. This is much greater transparency than can be found in many other collective investment vehicles.”

Lyxor Asset Management head of ETF strategy for Northern Europe Adam Laird says their ETFs are very large in size and this can mean they have “a huge” turnover. However, he says performance can be measured everyday against the index.

He says: “It’s vital we get the details right. Passive funds invest along with an index, so we’re not analysing company prospects, but there is still skill and care needed. We need to manage cash flowing in or out of the funds and look after dividends.

He says: “We’ve seen more and more demand for objective based funds – for example those that minimise risk or boost income. We need to make sure the index process is robust. If something doesn’t work, we’ll make a change.

“Passive competition is fierce and we’ve a duty to keep costs low for investors. We’ve cut fees on 20 funds this year, to make sure they’re the best value for our investors. We’ve made changes to structure to improve liquidity and to make sure our range suits investors today. We can’t rest on our laurels.”

But AJ Bell head of fund selection Ryan Hughes says while costs are important in ETFs, this doesn’t mean buying a cheaper fund is the right strategy.

He says: “Our team is constantly assessing the market liquidity, something that is key when looking at ETFs where we want to ensure we are able to trade in a cost effective manner. Some of the work we have being doing recently includes analysing the most appropriate time of day to trade certain ETFs as spreads widen or tighten depending on broader liquidity.

“The passive market has evolved significantly over the years and gone are the days of just buying the cheapest strategy. These are just some examples of the work we do on a daily basis to ensure that our funds are doing exactly what we intended.”

Due diligence sets the rules for what it invests in, he says, to make sure they are diversifies and have no hidden biases.

Concerns were recently raised that ETFs contributed to overvaluation in the equity markets, particularly the FAANG stocks in the US. But Sleep says quantitative easing and low interest rates play more of a role in valuations than funds.

Architas deputy chief investment officer Sheldon MacDonald says that while quantitative easing has significantly boosted the value of both equities and bonds, with returns far outstripping the earnings growth of companies, this has been exacerbated by the growth of passive investing.

“Most passive funds allocate capital according to market capitalisation. So as money flows into these vehicles, they all tend to buy the same stocks.

“As these stocks get relatively more expensive, valuation-sensitive active managers start to get nervous, and allocate into cheaper stocks. But the wave of investment into passives continues, favouring even more the already-expensive stocks: again, a headwind for active managers.”