Due to the strong growth and popularity of the ETF industry, ETFs receive a large amount of media coverage. While most of this coverage is positive and constructive, there are always a few ‘rogue’ articles (often written by active fund managers) which aim to point out the “dangers” of investing in these products. The primary thrust of these negative articles often centres around the riskiness of ETFs’ underlying exposures, as well as the postulation that ETFs are predominantly used as trading vehicles and can be illiquid (and therefore in times of stress or market downturn the investor may not be able to sell their position). I thought I would take the opportunity in this short post to dispel some of the commonly cited ‘myths’ and misconceptions of ETFs.
ETFs are investment structures, it’s what’s under the bonnet that matters
I remember my parents saying to me when I was beginning primary school and looking to make some new friends that it was important not to judge a person on what they were like on the outside but rather it’s what is on the inside that counts. Although the relative comparison here is extremely different, I would say that the statement applies in this instance as well.
An ETF is nothing more than an investment structure. More specifically, it is a type of open-ended managed fund traded on a financial exchange. In the case of Australian ETFs, they are traded on the Australian Securities Exchange (ASX) just like any share. A little-known fact is that ETFs are structured with the same ‘plumbing’ as traditional managed funds (i.e. they are both regulated managed investment schemes), and thus are subject to the same regulatory framework as managed funds. As a result then, to say that all ETFs are risky would be the same as saying all managed funds are risky, which is incorrect.
The key factor in determining the risk level of an ETF or managed fund is the underlying exposure of the fund. Needless to say, therefore, a cash ETF is going to be less risky than an emerging market ETF purely because holding cash is going to be less volatile than having exposure to emerging market equities. So you can see that stating that ETFs as a category are risky makes no sense!
You don’t buy and hold ETFs?
Even though ETFs are bought and sold exactly like a share and exhibit very similar characteristics in providing the ability to buy and sell during the trading day and investment transparency, the similarities seem to stop there in the eyes of some commentators.
It appears as though some people view ETFs as the sole trading vehicles available to institutional investors, brokers and fund managers seeking to move large sums of money in and out of exposures in short periods of time. My question is, however, doesn’t the same comment apply to stocks?
My point here is that just like there are investors who will buy ETFs as part of a tactical trade or take advantage of what they see as a misevaluation of price, the same will apply for those who buy stocks. A key example is that a stock like BHP trades at multiples of the average daily traded volumes of the largest ETF on the Australian market. On the flip side, just as there are some investors who have held onto CBA for the past 10 years there will also be investors who have held an Australian broad market equity ETF for the last 10 years. ETFs are flexible, to be used for both kinds of investor, and certainly, are not solely used for trading purposes or buy/hold purposes. Different strokes for different folks. As to the often cited liquidity concerns of ETFs, my colleagues have written extensively on this topic so rather than repeat them, for those interested in the liquidity of ETFs, I suggest you refer to this excellent post by one of my colleagues, Louis Crous. The summary, however, is that the best measure of an ETF’s liquidity is widely considered to be the liquidity of the underlying portfolio of securities. So, as long as those exposures are liquid, the ETF itself should have a high level of liquidity.
In summary, what I am trying to say here is that investors should not only focus on the structure of the investment but consider what they are getting exposure to. Whether you are investing in an ETF, stock or traditional managed fund, it really is what’s on the inside that counts.