The bottom line:
We believe all investors should as a minimum consider ETFs. For some investors, it may be possible to enhance returns and/or enhance liquidity thanks to some structural benefits that ETFs can provide (while not changing your asset allocation). This will not be applicable to all investors though, so this will need to be considered on a case-by-case basis.
The Exchange Traded Fund (ETF) market has grown markedly over recent years, rising from just under $2 trillion in 2010 to around $10 trillion in 2021.
The ETF offering has also expanded with more and more creative options coming to market: aside from your traditional S&P 500 or global aggregate bond ETFs, you can invest in AI, meme stock and even breakfast themed ETFs. Although a word of caution, this research suggests that the performance of thematic ETFs has in general lagged that of more traditional broader based ETFs, in part because by the time many investment ideas have become fashionable they have reached their market peak.
Growth in the market for ETFs
Source: Financial Times
Interestingly, ETF adoption has been widespread amongst investors: from individuals to sovereign institutions to asset managers. I find it fascinating to think that each time I buy a share in an ETF I could potentially be trading with a central bank or sovereign wealth fund. What other investment vehicle brings together such different types of investor?
Having said that, there are some pockets of investors where ETFs are seldom used. In this article I’ll explore some of the pros and cons of ETFs and set out a framework for measuring their attractiveness vs other types of investment vehicles.
Quick explainer: what is an ETF?
An ETF is like a fund in that it invests typically in stocks or bonds and usually aims to track an index. However, the key difference to a standard “mutual” fund or unit trust is that in the case of an ETF the fund itself is traded on an exchange (similar to how stocks are traded on an exchange). This improves accessibility and hints at an ETF’s first advantage: the ability to gain immediate exposure, rather than submit a request and wait days for the purchase or sale to be enacted.
Benefits of ETFs
The main benefits of ETFs are well documented and revolve around liquidity, intraday trading and ease of implementation. Indeed, in our Investment Uncut podcast, 91 portfolio manager Jeff Boswell discusses how active corporate bond managers are one of the largest users of ETFs thanks to the liquidity they can provide. Within equities, large inflows and competition has helped drive costs down, for example the cost of investing in an S&P 500 tracker ETF has fallen to below 10 basis points for the largest ETFs.
Innovations within ETFs have also resulted in efficient tax structures. For example through ETFs investors may be able to reduce withholding tax costs in US stocks or UK stamp duty due when buying stocks.
What are the risks?
The price of an ETF is generally kept very close to its intrinsic net asset value thanks to so called Authorised Participants (APs) such as investment banks monitoring the price of ETFs. If an ETF is trading at a small premium during the trading day, this is because there is excess demand for ETF shares. APs can satisfy this demand by initiating an ETF unit creation process with the ETF manager. An AP will buy the basket of underlying stocks and deliver that to the ETF manager in exchange for newly created units in the ETF which can then be sold in the open market, helping keep the price of the ETF close to its intrinsic market value.
What happens when liquidity is low?
Consider a bond ETF. In times of market stress, bond liquidity can suffer and this can have a knock on impact on the unit creation/redemption process of ETFs. If this process breaks, then the price of the ETF may start to deviate from its underlying market value. The next chart shows the performance of a UK corporate bond ETF vs its underlying index (rebased to 100) during the first few months of 2020 when the Covid-19 pandemic struck markets. The ETF significantly underperforms its index, driven by lack of liquidity in the underlying market.
Expected performance relative to net* benchmark due to sum of all cost and value add items
A widely debated topic in the industry is whether ETFs improve or worsen liquidity. Some argue that liquidity is improved and that where there are price differences between an ETF and an index, the ETF may be a better reflection of the “true” market value of those assets (if there is not sufficient trading in the securities in the index but the ETF continue to trade). This analysis around the time of the Covid-19 pandemic appears to support this theory.
Others, however, argue that ETFs can negatively impact liquidity in crisis type situations, particularly where an ETF does not fully replicate the index, as argued in this paper.
In any case, price discrepancies usually correct over time, meaning this risk only materialises if an investor needs to sell its holding.
How can investors decide whether to use ETFs over other vehicles?
Because the economic exposure provided by ETFs can in some cases be provided by other instruments (eg by physical funds and derivatives), we believe that costs will be a key factor for investors when deciding which instrument to use. Investing in a lower cost product will ultimately translate into higher returns.
A “Total Cost of Ownership” framework can be used to evaluate the pros and cons of each investment. This framework includes all sources of cost (such as transaction costs, ongoing charges, etc) as well as potential revenue sources (such as from securities lending or tax advantages) which may not be obvious at first sight.
We have provided an example of this framework in practice in Figure 2. The key takeaway from this section is that investors should run their own equivalent analysis incorporating for example their own tax status and fee arrangements which can make a big difference to the outcome of this analysis.
Expected performance relative to net* benchmark
Note: Chart shows total costs relative to a net of tax benchmark, so any tax advantages through the holding period are positive in terms of returns
This example compares a US equity fund (that incurs withholding tax) to two ETFs, one where the underlying holdings are physical equities and one where the underlying holdings are derivates (swaps). The table shows the assumptions we have made in this TCO example.
In the table you see that the big difference is the “withholding tax efficiency gain”. ETFs in certain domiciles are not subject to full US withholding tax and this benefit is amplified if the ETF is structured around derivatives rather than physical equities. This efficiency gain means that the ETF is expected to outperform a net of tax benchmark as shown in the diagram. This is a good example of how ETF managers are able to innovate to deliver better returns for investors.
Note: some investors such as pension schemes are not subject to tax so are able to avoid US withholding tax by investing in physical equity funds that are specially created for pension schemes.
Note: we have not factored in two items in the TCO analysis: 1) custody costs that may be charged to the investor for holding the ETF units and 2) potential revenue derived from ETF unit lending (which can be additional to securities lending, which we did account for). Custody costs would act as an additional drag on ETF returns shown however as these are individually negotiated by investors we could not include them. That said we would expect them to be small overall. Unit lending refers to lending the ETF units that an investor holds (similar to securities lending but at the ETF unit level). As this feature of ETFs is optional we have not included it in the analysis, however if unit lending is a feature that an individual investor is considering, then we would recommend including it in the TCO analysis.
Source: Bloomberg and some TCO data elements provided by BlackRock. Note: cost of manager buying and selling underlying securities (eg when there are index changes) in fund are not included in TCO analysis. We would expect these to be minimal and largely the same for fund and ETF.
An ETF is a tool in every investor’s tool box (whether they use it in practice or not). We think all investors should as a minimum consider them when deciding how best to achieve a desired exposure, evaluating the pros and cons vs other investment vehicles. When estimating costs, don’t fall into the trap of looking at the headline fee only. Consider all sources of cost/revenue to build the complete picture.