JPMAM’s Lake: ETFs aren’t just about passive

Anyone who’s watched a toddler grasp an Apple device (aka the “digital babysitter”) and operate it with the sudden ease of an engineer knows that the technology is inherently intuitive. I’m tempted to think iPads are the developmental equivalent of building blocks for the touch screen generation.

I would argue there’s some conceptual or structural similarity between exchange traded funds (ETFs) and iPads, if only in the sense that both offer simplicity at the point of use in a fashion that is intrinsically compelling to digital natives.

ETFs are usable by investors of all sizes and shapes for a variety of investment demands. Individuals tend to like them for easy access and low fees, whereas institutional investors find them helpful as advanced portfolio management tools. In essence, they are portfolio building blocks for the modern age, capable of providing a delivery mechanism for myriad types of underlying strategies. In the same way that an iPad easily transitions from a toddlers game to a parent returning email for work, the ETF has unlimited applications as well.

This foundational characteristic of ETFs is sometimes lost on investors who conflate ETFs with passive investing.  While it’s true that ETFs are often used for passive market-capitalisation weighted index tracking, that’s not intrinsic or inherent to the ETF as a vehicle.

ETFs and mutual funds share a fundamental commonality: both are pooled investment vehicles. Beyond that, they diverge to suit different investor needs, and ETFs can provide desirable benefits and flexibility.

ETFs are listed on an exchange and traded throughout the day, whereas mutual funds trade at a set point each day. ETFs are also structurally different. They take in and disburse assets through a creation and redemption process, minimising or eliminating the impact of fellow investors actions in the fund. Because ETF share prices are set in relation to the assets for which they can be exchanged, they can act as a kind of transference mechanism, giving the holder the performance and liquidity of the underlying holdings in a convenient wrapper. Removing the execution process from the fund management process and a few other efficiencies due to clever design can also lead to lower expenses which are passed on to investors.  

Without getting too technical, the details of the creations and redemptions and the utilisation of liquidity providers are critical functions of the ETF structure and responsible for the vehicle’s structural advantages relative to mutual funds. They’ve enabled a number of features that both institutional and retail investors find attractive, including real-time pricing and trading, enhancing the ability to be more tactical in seeking out market exposures. Indeed there are moving pieces behind the scenes but the key is that ETF usage is intuitive in the same way that there is tech behind the screen of the iPad, the usage is totally intuitive.

ETFs are transparent exchange listings that enable a wide variety of market participants to apply the principles of modern markets to the investments they deliver. And the products inside the ETF wrapper can be varied – including strategic beta or even actively managed investment strategies across myriad different asset classes.  The core characteristics of the ETF wrapper are the same no matter what investment strategy is delivered in the vehicle. 

It’s unfortunate that ETFs have been considered synonymous with passive in the public imagination. To be clear, ETFs in themselves aren’t an investment strategy, per se, much like the circuit boards of an iPad isn’t the final product of an iPad. Interchangeable use of the terms ‘passive’ and ‘ETF’ does a disservice to investors and creates needless confusion around recognising the true structural advantages of ETFs.

ETFs are not (just) about passive investing. They allow access to many different investment products at the click of a mouse through an electronic brokerage account, and in so doing bringing many of the tools of the institutional investor universe into the hands of the masses.  At heart they are a wrapper and not encapsulated by any one investment approach, but rather connected by a single unifying characteristic – accessibility.

Bryon Lake is international head of ETFs at J P Morgan Asset Management