Exchange Traded Funds market up 90% to $3.5t

Dr Marie Owens Thomsen

MANAMA: The market of exchange traded funds’ (ETF) total assets under management (AUM) reached $3.5 trillion.

In her Indosuez Wealth Management’s Macro Insight report by their Global Head of Investment Intelligence, Dr. Marie Owens Thomsen maintained that in 2016, the ETF market totalled USD 3.5 trillion in assets under management, representing a rise of 90% in five years and approaching five per cent of total global assets under management.

“The number of ETFs in the world was close to 4,400 at the end of 2015, up nearly 50% from year 2000. In spite of such a formidable offer, the vast majority of assets are controlled by the three largest ETF issuers: BlackRock, Vanguard Group Inc., and State Street Corp. Together these firms account for approximately 90% of ETF daily trading volume occurring in a collective 1’200 funds,” she said.

“The EFT assets under management are overwhelmingly invested in US equity (Table 2). The second-largest asset class is international equity, followed by US fixed income. Commodities then come a distant fourth, followed by international fixed income. For portfolio optimisation purposes it is normally preferable to diversify one’s assets and seek to avoid concentrating risk too narrowly. Funds of various shapes and forms allow investors to do this in an efficient way while single stock or bond investments might not achieve the same degree of diversification depending on the size of the individual investment portfolio. There is, however, an additional risk in the form of the issuer of the fund – the counterparty risk. Not only might the market fluctuate but the counterparty could run into trouble,” she added.

“One would think that regulators ought to be concerned with the concentration of ETFs in the hands of a limited number of providers, and possibly also with the concentration of assets under management in those funds in particular segments of the markets. Moreover, there is a concentration of ownership in the US stock market that deserves attention. Almost 12% of the S&P 500 was owned by ETFs as per the middle of 2016, according to the Wall Street Journal.”

“When large numbers of shares are in a sense “forcibly” owned because of the need to replicate index weightings, the number of shares traded freely falls which can have an adverse influence on liquidity and can also induce valuation distortions as well as erratic price movements. Passive investing arguably enhances these trends, and concentrating one’s assets in crowded trades is a high-risk strategy that tends to be accompanied by higher volatility than stocks with a lower concentration of ownership.”

“An index-following ETF is a long-only strategy and it includes the whole market in question, in the proportions dictated by the index. This is generally speaking a good strategy in a context in which the whole market is rising simultaneously. However, when one portion of the index is rising and another is falling, an active management might be able to stay clear of the part that is under-performing – an option that is simply not available to the passive fund manager. In the case of the spectacular fall in the price of oil, the energy sector within the S&P 500 fell by 25% in 2015. The passive investor would have been exposed to this drop to the height of the sector’s weight in the S&P 500 (six per cent), while an active fund manager could have reduced that exposure.”

“Every index has its bias, and it is often the case that there is some part of the index that one might rather not own. This inconvenience has to be weighed against the low cost and ease of use that ETFs offer. The notion that investing in passive ETFs is somehow inherently “safer” than active investment centres on the fact that the passive investment manager’s task is limited to mimicking the allocation in the index. Hence, passive investing reduces the risk exposure to the skills of the fund manager, for better or for worse.”

“Passive index following does not necessarily reduce exposure to market risk, and it might actually concentrate market risk in surprising ways in the case of certain indices, as discussed above, and as we shall see below. Moreover, passive investing exposes the investor fully to his or her own skills, in terms of being able to pick the appropriate EFTs. We insist again on the importance of seeking advice, but also on the duty we all have to ourselves to stay informed. Ideally, in the interest of diversification, a mix of active and passive investment is likely to be the optimal solution for most investors as either investment style tends to do well in different types of markets. Choice and proliferation of instruments are important features of broad and deep financial markets and generally speaking, the more the merrier. Hence, our aim in this paper is not to discredit ETFs – only to avoid ascribing paranormal properties to this form of investing. Selling ETFs as low-cost investments is accurate. Selling them as less risky investments is erroneous.”

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