Don’t invest in lemons

The big trend in using ETFs can be explained with a bit of Nobel Prize economics.

In 1970 the economist George Akerlof published a paper entitled The Market for Lemons: Quality Uncertainty and the Market Mechanism. Akerlof went on to share the 2001 Nobel Prize with Michael Spence and Joseph Stiglitz for their work on asymmetric information.

Putting aside the big words, one can identify in their paper a simple concept that explains the increasing popularity of ETFs.

The paper uses “lemon” for its slang meaning of a poor quality, used car, rather than its traditional definition as a citrus fruit. The paper considers what consumers do when they are uncertain about the quality of a product. Basically, they shun lemons.

The principle is as follows:

• When a potential purchaser looks at a used car he can’t be certain what shape it is in. He won’t assume high quality. He will only offer a price based on an assumption of average quality.
• Anyone with a high quality car to sell won’t sell it for the price purchasers are willing to pay. Owners of high quality used cars therefore don’t participate in the market.
• The market is consequently dominated by low quality cars with a deficiency of high quality cars.

Old Holdens with dodgy engines are just an example. The principle extends to any products and services for which quality is not transparent.

For example, if someone knocks on your door offering to mow your lawn with a new contraption that utilises artificial intelligence, drone technology and laser beams for blades, you are likely to be suspicious. You may be willing to risk a small payment but anyone who truly has breakthrough technology is not going to accept small payments while marketing door-to-door. You are going to turn this person away and get the kid next door to mow your lawn the old-fashioned way.

If the quality isn’t transparent and sellers are just asking you to trust them, you are likely to go somewhere else.

We are seeing this in the market for investment products. The growth in index funds continues to outpace other investment choices. In Australia this is playing out on the ASX where ETFs, which are index funds traded on the exchange, surpassed a record $12.7 billion in assets last month.

A big part of the attraction is that investors trust ETFs more than other investment products because they are transparent. The makeup of an ETF’s portfolio is available on a daily basis and its index rules are published for anyone who is curious. Most investors don’t check these things out but they know instinctively there are enough sophisticated investors, consultants, researchers, and journalists out there who are watching closely. If an ETF provider starts to go off the rails, the market will find out very quickly.

Other managed funds are not transparent. You don’t have any idea how they do what they do. You don’t have any idea what’s even in the portfolio. There are government proposals for unlisted funds to disclose their portfolio holdings and many fund managers are lobbying against them. Their argument is that they don’t want to give away their “intellectual property.”

Many unlisted managed funds are high in cost and opaque. ETFs are low in cost and transparent. You can understand why they are increasing in popularity.

Market Vectors Australian Equal Weight ETF (ASX code: MVW) is a one-of-a-kind ETF that provides a low-cost transparent portfolio of the most liquid ASX-listed companies. It is increasingly being used in model portfolios.

Also available are the following sector-specific ETFs: Market Vectors Australian Property ETF (ASX code: MVA), Market Vectors Australian Banks ETF (ASX code: MVB), Market Vectors Australian Resources ETF (ASX code: MVR), and Market Vectors Australian Emerging Resources ETF (ASX code: MVE).

The holdings of our ETFs are available on our website daily. It’s important that you understand your investments – you don’t want a lemon.

If you would like to speak to one of our ETF specialists to understand what is under the bonnet of our ETFs, email us at info@marketvectors.com.au or call 02 8038 3300.

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