ETFs: Is overtrading a problem?

Late last year Jack Bogle, one of the legends of the passives industry, made headlines when he criticised the high-trading mentality of ETFs and pointed out that non-listed index funds were a superior investment.

There is no arguing with the data. Bogle highlighted the 800 per cent turnover and 1.6 per cent underperformance of ETFs relative to the index funds in an opinion piece penned for the Financial Times. The more investors trade, the more their returns fall short of the stockmarket return, Bogle argued.

Overtrading and product over-engineering has always negatively impacted investors. ETFs do bring out these flaws. However, technology and new business models means there is more going on than meets the eye.

Bogle points out that people are flawed, as seen in behaviours such as overconfidence, anchoring and loss aversion to name only a few. Most institutional investment firms still make their investment decisions through large committees of analysts, fund managers and strategists.

Looking at the semi-annual S&P Indices Versus Active (Spiva) report makes dour reading for how brilliant these committees really are. Last year’s results show two out of three US active large-cap funds underperforming the benchmark and that worsened to more than 80 per cent for the five-year and 10-year periods. However, software can address the problem by getting rid of the swathes of committees and egos. The cost savings and therefore additional returns can be passed directly on to retail customers.

This means using technology and the benefits of ETFs (low-cost, liquid, transparent and being exchange-traded) while eliminating some of the flaws of the workmen that have historically used these tools. There is a natural flaw in allowing investors (and algorithms) to overtrade. This is succinctly pointed out in the turnover and underperformance of ETFs relative to the index funds Bogle cites.

However, as he also pointed out, ETFs have allowed the rise of robo-advisers. Due to the cost-efficiency, liquidity and exchange-traded nature of ETFs, software-driven asset allocation models could effectively be built. This means a new breed of investment manager has been able to use the benefits of ETFs and technology to offer services normally reserved for private bank clients at half the costs of traditional firms.

This impact has forced incumbent firms and regulators to take notice, and drive costs lower for the industry as a whole, in order to compete. All for the benefit of the average investor.

Bogle used the word “incipient” to describe the rise of robo-advisers. That is undeniably true, however, as in most industries there is a bell-shaped curve with an average and left and right tails.

As technology starts to play a bigger role in investment management, algorithmic trading and automated fund management could take a larger share of the industry and market turnover going forward. With more of the market potentially being driven by machines and software, will this mean even greater portfolio turnover, trading and, as was pointed out, laggard performance?

Investors have to understand what they are getting when they choose a robo-adviser. How many firms actually offer more than just three to five standard portfolios? How many types of currencies are they able to invest in to truly hedge investment risk in a world with increasingly challenging macro trends? And despite citing low management fees, how low are their “all-in” fees really when adding the total expense ratios of the underlying ETFs most robo-advisers use?

I mostly agree with Bogle. However, technology has allowed new firms to use ETFs and create services that are more tailored, more transparent and ultimately lower in costs all for the benefit of investors.

And that can only be a good thing.

Johann Bornman is a product and sales director at ETFmatic.