Active investment worldwide is declining and funds are reallocated to passive investment strategies through index funds and Index ETFs.
Active managers should and are worried about this trend and attack the use on ETFs on several fronts:
Myth # 1: ETFs distort markets
As for ETFs making markets dumb, they simply don’t own enough of the market to have real impact on the price discovery process. In Australia ETFs account for $28 billion, less than 2% of the overall market. Furthermore, they don’t trade nearly as often as active investors. Index ETFs by definition trade their holdings rarely so most of the time they just hold. Even in the US where indexing accounts for 28% of the market, the overwhelming majority of trading is still done by active investors. To say ETFs indiscriminately drive prices up and down is plain wrong. If ETFs were causing shares to be mispriced this would create arbitrage opportunities for active investors. Active fund managers would be celebrating, not bemoaning ETFs! Active managers are important as they try to value a company correctly and buy the undervalued and sell the overvalued.
Myth # 2: ETFs cause market bubbles
There are always market bubbles, lies in human behaviour and they happened when ETFs weren’t around and when they were around. The cause of bubbles is human behaviour and not a certain financial instrument.
Myth # 3: ETFs have liquidity issues
ETFs can only be as liquid as the underlying asset / share. Insufficient liquidity in the underlying will translate into insufficient liquidity of the product be it a passive product like an index ETF or an actively managed fund. Again, it’s the market not the product.
Are there dangers of ETFs?
Yes, the new breed of triple leveraged ETFs in the wrong hands but not different to trading other leveraged markets. It’s excessive leverage done by uneducated investors that is the problem not the product itself.
ETFs and passive investing will continue growing but that does not mean you can’t time the market. You can use an index ETF as a surrogate for a basked of shares and trade this like a share in a low cost manner. Buy and stay long in an uptrend and go into cash or reverse to short in a downtrend. You can apply our share trading system easily to index ETFs and use these products to actively trade the markets to avoid the buy and hold return / drawdown characteristics. Many CFD brokers in Australia also let you trade CFDs on ETFs and you can thus leverage standard ETFs and go short the major ETFs. So ETFs are just one more instrument to trade and get exposure to different countries and market segments. Even if most ETFs tend to be passive investments you can also – as we do – trade them actively and use them efficiently for market timing. Choice is good and ETFs increase our investment choices.