Passive Battles
The dismal science might be getting a battering during these volatile times, but as a former academic this burningpants correspondent can’t help viewing new developments in the financial world through the prism of basic economic principles, particularly the simple concept of substitute goods.
Don’t worry, this won’t be a tour of differential calculus nor will you be lectured on the relationship between the demand schedules of two goods – but it does provide a nice context to discuss the increasing interest in Australia for exchange traded funds (ETFs) and their closest relative, the conventional index managed funds.
ETFs are quite simple products to understand which may explain their popularity. Essentially, they are investment funds traded on an exchange that invest in a basket of securities that, generally, seek to track the performance of a specified index.
Much has been written on the subject of ETFs recently. While The Economist highlighted some potential risks of ETFs with the rise of synthetic ETFs, the general consensus is that the instruments will prove useful to a range of investors. SMSF trustees, for example, will be able to enjoy low entry prices, transparency and tax efficiency.
So should managed fund managers, especially those of conventional index mutual funds be afraid? Will we see a massive movement of capital to ETFs from managed funds?
On the surface they are very similar. Both seek to provide investors with a means of owning a well-diversified indexed portfolio – let me not bore you about the efficient market hypothesis here. The best way to consider this possibility is to consider to what degree the two investment products are substitutes for each other.
It is very easy to see where ETFs have the advantage. They offer the potential to achieve high risk diversification, brokerage and management fees are much lower than traditional managed funds, they offer plenty of liquidity compared to managed funds and perhaps most importantly is the accessibility of these products.
The ability to trade intraday is seen as a big plus, but that would only be an issue if major volatility is being observed. A substantial advantage, certainly for institutional investors, is that they can be sold short facilitating the design of new hedging strategies.
If ETFs are good substitutes, one would assume that gradually the conventional managed fund would disappear. Yet there are still certain advantages for traditional index funds.
If an investor is frequently rebalancing their portfolio – ETFs might be a bad of way of going about it.
The associated commission or brokerage fees will rapidly eat away at returns. Aside from the standard fees on index managed funds, there are no shareholder transaction costs, (except for funds with loadings), not to mention the economies that some of these funds have.
Liquidity of ETFs is also seen as a big plus. But, liquidity concerns are still there in the background. There is the issue of the bid-ask spreads on these products – the spread may be quite large particularly when the underlying market or security is illiquid.
The spread represents a “hidden” fee which doesn’t make these instruments all that agreeable to investors who will hold them for very short lengths of time. In contrast, in a conventional index managed fund there is no bid-ask spread.
Much has been made of the advantages of ETFs, however, there are still definite advantages to conventional index funds for advisers. They don’t appear to be perfect substitutes for each other just yet.
One Comment on “Passive Battles”
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Darren Layton says:
Thanks for the great article.
I thought that some index managed funds do have buy sell spread’s, for example the Vanguard Index Australian Shares Fund has a buy sell spread of 0.1% / 0.1%.
I see that the use of ETF’s is likley to increase with the uptake by the directive investor and those advisor’s who are comfortable with the use of direct shares / listed investments.
I know that many of my clients are asking about them and we are starting to use them more widely.