Dr ETFs or: How I learned to stop worrying and love markets

John Bogle is cited as the ‘father of index investing’ and in his last book, Stay the Course (2018), he acknowledged the vilification of passive investing, “Despite the success (or perhaps because of it), in recent years index funds have come under attack on multiple fronts. Yes it seems ridiculous that an innovation that has enabled investors to earn their fair share of the returns generated in our stock and bond markets is now under fire.”

Bogle endured these criticisms throughout his career. As we pointed out in ETF Myths Busted, “the hysteria about ETFs was based on myths. Much of the negative focus on ETFs has been written by those who stand to lose the most.”

Though most of the worries have never played out, investors do not want to be wrong so we thought we would go through them again here with a fresh approach. In The Bogle Effect (2022), Bloomberg’s Senior ETF Analyst Eric Balchunas, successfully deconstructs popular ETF criticisms while highlighting that it “is a good way to learn about how index funds and ETFs fit into the broader picture of markets.”

In that spirit, let’s go through the eight biggest worries regarding passive investing Balchunas identified, through an Australian lens.

1 – Causing stock market bubble

Critics of ETFs point to their growth, saying it will cause a ‘bubble’ indiscriminately pushing up prices. ETFs are growing, from around $10 billion in 2012 to be in excess of $130 billion now. So the ‘bubble’ theory sounds like a legitimate concern, until you add context.

Over that same time the market capitalisation of all companies listed on ASX’s grew $1.4 trillion, from $1.2 trillion to be around is $2.6 trillion today. This dwarfs the growth of ETFs.

In addition, of the $130 billion invested in ETFs on ASX, investment in Australian equities represents only around 37%. ETFs also invest in assets like global equities, infrastructure and fixed income.

2 – Distorting the market

Going hand in hand with the ‘bubble’ prosecution, is the distorting the market argument. The concern is that ETFs, by just tracking an index, mindlessly drive up prices by buying stocks regardless of fundamentals and as a result companies are not being correctly priced.

Ignoring the fact that there has been example of mispricings, booms and busts since well before passive funds, there has also been a steady stream of examples when a company’s price rises and falls quickly after good or bad announcements or news since the rise of passive funds, as you would expect.

Balchunas cites General Electric, once the biggest company in the S&P 500. In 2018, the company’s share price plummeted 50% over ten months for fundamental reasons, namely weak profits and climbing debt, yet ETFs that included that mega-cap were growing. There have been examples in Australia too. Fund managers Perpetual (during 2017-2018) and Magellan (during the past 12 months) experienced share price falls despite flows into ETFs that held the companies. This is because other market participants, including active funds, sold them and decreased their size.

“A good way to think about it is that index funds and ETFs are in the backseat of the car that active players are driving,” writes Balchunas, “Case in point: Apple and Microsoft are currently at the top of the S&P500 Index, not because passive funds are popular but because their market cap is the biggest. And the reason their market cap increased is that their price increased. The reason their price increased is that active traders like the stocks and bought them. And at some point down the road they will stop wowing active players who will sell them and then they will stop being the top two companies. The index is a dynamic, constantly changing organism thanks to active management.”

3 – Never been tested

Balchunas describes this criticism as the most absurd and easiest to refute. The fact is, ETFs have been tested across multiple cycles. ETFs have not only survived stress tests, they tend to thrive in them.

In Australia ETFs saw increased volume during the GFC, the ‘taper tantrum’ in 2013, Brexit and the March 2020 sell-off caused by the COVID-19 lockdowns. In all ETFs have tended to be the most liquid vehicles, being used by sophisticated traders.

The track record speaks for itself.

4 – Creating a liquidity mismatch

This criticism seems to be aimed at bond ETFs. To start with, the liquidity of ETFs and the rules that they operate under are not well understood by most critics of ETFs. We have written about ETF liquidity previously - here.

The reason liquidity relates to bond ETFs is that the underlying bond assets do not trade ‘on exchange’. Rather, bonds trade ‘over-the-counter’ and the sharpest criticism of ETFs has focused on the liquidity of these over-the-counter (OTC) markets. These same markets active bond fund managers trade in.

Banks and brokers make OTC markets possible by facilitating bond trading between institutions. Under normal market conditions, they generally carry a book of bonds on their balance sheet to assist trading and making a liquid market.

There is however a limit to how much they can hold on their balance sheets. In a market environment where there are more sellers (of bonds) than buyers, selling bonds at fair prices becomes difficult. This causes a ‘liquidity crunch’.

We saw this in March 2020. Some bond ETFs experienced wider buy/sell spreads. This is because, as liquidity in the underlying OTC bond market dried up, spreads widened to reflect the lower (discounted) prices that the underlying bonds could trade for OTC. This was then reflected in the price of the ETF, as a discount to the Net Asset Value (NAV) of the fund’s underlying holdings.

But as was pointed out in a Wall Street Journal article, ETFs Have Passed Their Covid-19 Stress Test, these bond ETFs were more of a reflection of where the OTC bond market was at, and that bond prices “need(ed) to catch up”. Following this same point, Robin Wigglesworth in the Financial Times said, “Moreover, the discounts meant that sellers of the ETF bore the cost of instant liquidity, rather than the remaining investors in the fund. This is a fairer outcome than what happens with traditional bond funds, which often sell their most liquid, higher-quality assets to accommodate outflows, leaving remaining investors holding an inferior portfolio.”

5 – Weak hands

This is the worry that ETF investors will run for the hills at the first moment of trouble. Balchunas shoots this down by pointing out:

• Every time we’ve had a sell-off, the exact opposite happens;
• Many passive investors are self-directed who chose to buy the funds they are in and are thus more loyal to the fund; and
• Investors in ETFs tend to be younger and so do not need to cash out of the investments.

According to Balchunas, “for the foreseeable future, look for passive investors to be strong hands, not the weak ones.”

6 – Too many indexes

There is a concern there are too many indexes and too many ETFs. According to the Financial Times, in 2018 there were more than 70 times as many stock market indices as there were quoted stocks in the world.

That maybe, but according to Morningstar, there are 3,689 Australian Investment Trusts in its Open End Funds database. All Offshore Open End Funds total 113,614. According to ASX and The World Federation of Exchanges, at the end of Q1 2022 there were 2,177 ASX listed companies and 58,200 listed companies around the world. Even though there are more funds than listed companies, we have never seen a story about that.

Balchunas, clearly an avid music fan, cleverly cites the fact there is an estimated 97 million unique songs that use just 12 notes. “Yet of all those words and songs, only 0.1 percent resonate with the public while the rest live in oblivion. The same is true of indexes. Only a microscopic number will ever be turned into investment products such as ETFs.”

To give context, on ASX there are only 187 ETFs that track an index.

Too many indices is not a worry for the market.

7 – Ownership concentration

This is a little more complex. A review of the top ten companies on ASX, which represent almost 50% of the Australian equity market, reveals that the three largest passive managers globally feature. It is important to note that no passive manager owns more than 9% of an any of these companies and as a percentage of the total market capitalisation, these three passive managers own just 12% of the top 10 ASX companies. When you add up the collective ownership of active managers, it is well over 12%, it is just that active management is distributed among many managers, not three. The ownership concentration argument may be overstated.

That is not to say the rise of passive management is not a concern in this respect, especially because with ownership comes voting power.

Proxy votes are collective ballots cast on behalf of investors at company annual general meetings. Examples include proposed changes to share ownership, the structure of the board of directors, merger or acquisition approvals, and executive salary and benefits.

From VanEck’s perspective, contrary to popular belief, passive ETFs which track indices do make active decisions when it comes to proxy voting elections.

At VanEck, we monitor and review all proxy votes. We also use Glass Lewis for assistance and they have developed a specific set of ESG proxy voting guidelines that closely align with our views and in our opinion satisfy the high standards expected of a fiduciary.

As an example, we recently voted against the remuneration report for listed property giant Dexus because we felt the amount of one-off bonuses was too high.

You can read more about our approach to proxy voting here and view our proxy voting reports here.

8 – Bad customer service

Critics wonder, how can a passive manager afford to provide good customer service given the low fees that they charge?

Let’s qualify a few things. Passive managers track an index, so investors know what they are getting: index returns less fees and any other slippage (also known as tracking error). Furthermore, ETFs that track indices are fully transparent. Investors know what they are holding every single day.

Alternatively, active managers that persistently underperform have created an uncertain experience. Furthermore, they are not transparent, so investors do not know what is in the portfolio. Many active managers only entrust their clients with top 10 holdings, provided well after month end.

The point is, ETFs empower investors and that caters for a better service experience.

Additionally ETF issuers such as VanEck are hyper-committed to education. The basis for this was that, initially, ETFs were a new innovation. Therefore, ETF issuers had an impetus to educate investors about their benefits. This has transposed to education on broader investing, portfolio construction and the range of investment opportunities and strategies available.

VanEck is committed to providing the best for its customers. Our Learning Hub has, among other things, information on ETFs, assistance with trading ETFs and education about the asset classes our ETFs invest in.

It is also easy to contact us and our details are noted below.

In The Bogle Effect, Balchunas debunked much of the hysteria about ETFs.

We too, think ETF investors are strong hands, recognising the importance of looking past the positive and negative commentary and concentrating on long term goals. A financial planner or stockbroker is best placed to help more.

To learn more about the ETF market, our ETFs and for guidance on best practice ETF execution, please visit our website vaneck.com.au or call us on 02 8038 3300 or email us at info@vaneck.com.au.