What Investors Should Know About ETFs

The rise of exchange-traded funds (ETFs) has been tremendous, taking a growing percent of investment fund flows. Some commentators have predicted ETFs inflows of $1 trillion in 2018. As it currently stands, the size of the global ETF market is $4 trillion, while the number of ETFs registered in the United States has reached 1,800.

ETF growth is part of a larger trend towards passive investing, which is what ETFs represent. Though currently popular, the concept of passive investing is not new. It was first introduced by John C. Bogle, an American investor and the founder of The Vanguard Group in the 1970s. 

The first ETF launched in 1993. Between then and 2000, active investing still represented the largest portion of global assets, at about $1 trillion, and active flows were over four times that of passive funds during this time. A shift came soon after the turn of the century though and has remained largely intact since. Between 2001 and 2008, passive index investing flows, mostly ETFs were positive, while active investing experienced outflows.  The trend grew from there. Between 2009 and 2016, active funds saw further outflows, while passive inflows totalled around $1 trillion.

According to the Investment Company Institute, as of 2016, US domestic equity index funds have surpassed assets of $3 trillion, of which about half are ETFs and half are passive index mutual funds.

The Appeal of ETFs and Passive Funds

According to commentators, passive funds like ETFs are appealing due to their lower fees. They can also offer instant diversification, as they follow broad indices such as the S&P 500, often with a portfolio of blue-chip stocks. They are also liquid, trading intraday like individual stocks, unlike mutual funds that only settle at the end of each trading day. For the average investor, passive funds with minimal fees imply safety, in the sense that you are simply following everybody so you won’t be underperforming the crowd, and there is also lots of liquidity.

For an average investor, if you are in a bull market and believe it will continue to move up consistently, then passive investing in a diversified index fund is attractive. The costs are low and you know you're getting full exposure to the market.

Some commentators have noticed that index investing reaches the highest level of popularity when bull markets are ending and nearing their peak. For active investors, there's a good chance they are reducing their exposure at the top of the market while the index funds are fully invested. As the bull market continues, they will outperform the more risk-averse active investors. Passive investing also removes the burden of deciding what stocks to invest in and when to buy or sell. It also removes the blame for bad decisions because losses can always be attributed to the market and not to the individual investor.

But passive funds also carry risks.

The Risk of Passive Investing

Just as an investor will benefit from the bull market rise, they will also suffer the consequences of overvalued stocks during bear markets. Indices are constructed according to the weighting of each company's market capitalization and free float. The largest companies receive the higher weighting in the index and in the ETF or index fund. Since the large stocks account for the highest weighting in the index, when there's a downside in the market, the selling pressure on the largest stocks will be greater. For example, only 50 stocks account for about 50% of the S&P 500 index capitalization, and thus makes up one half of an index fund's portfolio.

Another risk is that intra-day liquidity for ETFs can be challenging during market downturns. Algorithmic trading has exacerbated this risk. When there's a market dislocation and the ETF and index fund algorithms rapidly place sell orders to follow the market down (they are, after all, mandated to follow the index – regardless of direction) massive sell orders could trigger selling halts. Thus, the liquidity dries up, pushing investors to sell at significantly lower prices than the actual net asset value of the fund.

Despite the disadvantages of ETFs and index funds, they do serve a function. Investors seeking exposure to a particular market or market segment quickly can do so using them. However, there will always be a place for actively managed funds.