This is the second post in a series I am doing, in which I provide answers to the questions I most frequently get from investors and advisers on ETFs – trying to separate fact from fiction! In my first post, I provided answers to some commonly asked questions around ETF liquidity. In this post, I address the fiction that ETFs are “inherently complex and risky”, and also answer the query we sometimes get as to whether ETFs are, in fact, causing a “passive investment bubble”.

Fiction: ETFs are complex and risky

Like many claims made about ETFs, this is an argument that conflates a number of issues. For starters, it is true that – especially in offshore markets – the fast-growing ETF market has seen the introduction of more niche or seemingly complicated investment exposures – such as high yield junk bonds. But the point here is that what is complex is the investment exposure itself , which has nothing to do with the ETF fund structure which is used to offer these exposures to investors. As ETFs are essentially a producer wrapper (i.e. rather than a product in and of themselves), in terms of underlying investment exposure, ETFs can be simple or complicated – it is wrong to lump them all into either category. As with all investment products, it is up to the investors (with their advisers), to decide just how simple or complicated they want their investments to be. In this regard, ETFs are no different to traditional unlisted managed funds.

There is then a separate issue related to derivatives and “synthetic” ETFs. As a great rapper once said, “Don’t believe the hype!”. This is another argument that emanates from the way products can be structured in overseas markets and has no bearing on our market here in Australia. Let’s start with a bit of terminology. So-called “physical” ETFs gain exposure by buying underlying securities (like stocks) to track or replicate an index – with these assets then held on trust by the issuer (or via a third party custodian) for the benefit of investors.

By contrast, a synthetic ETF is one that obtains its investment exposure with the use of derivatives. This usually takes the form of a contract with an investment bank – through what’s known as a “total return swap” – to have that bank provide returns that match the required investment exposure. Critics claim that the issue with such swaps is that they can give rise to “counter-party risk”, to the extent that the investment banks which provide these derivative agreements could go broke and not live up to their contractual obligations.

In the case of Australia, concern over synthetic ETFs is largely misplaced. Having benefited from international experience, Australian regulators have been far stricter on the use of such instruments. Firstly, most synthetic ETFs in Australia are, in fact, virtually 100% cash backed – meaning that while total return swaps are used, the fund itself (and not the swap counterparty) holds 100% of its asset value in cash (which in turn is held in a third party custodial account). Secondly, Australian regulations limit the allowed amount of counterparty exposure to a small percentage of the ETF’s value at any time – if exceeded, the counterparty must deliver assets to the ETF to reduce the exposure.

Last, but not least, among the more than 200 exchange traded products now available on the Australia market, currently only four are synthetic. Three of these are in fact BetaShares’ commodity ETFs covering oil, agricultural and broad commodities. And indeed, the only reason why derivatives are used here is that it is not economically practical to hold and store these commodities (eg live cattle, grain, oil, etc), in order to create ETF exposure to these assets. The valuations of these ETFs are “marked to market” each day and this valuation is then backed by cash.

Fiction: there’s a “passive investment bubble” that is distorting market valuations and could lead to a crash

This is a relatively new argument and clearly reflects a reaction (largely propagated by active managers) against the strong growth in ETF funds under management across the globe in recent years. For this argument to be true, it would need to hold that ETFs have produced a large net-increase in investor equity demand. Yet the evidence suggests most of the flows into ETFs have come at the expense of traditional actively managed unlisted funds. According to data from the Investment Company Institute, for example, between 2007 and 2016, actively managed US domestic equity funds experienced a net outflow of $US 1.1 trillion, while flows into passively managed US equity ETFs and other unlisted funds were $1.4 trillion.

Even in the mature ETF market of the United States, moreover, ETFs still represent only a relatively small share – around 6% – of total equity market capitalisation. In Australia, the total value of Australian equity ETFs as at end-June was only $12.6 billion, or only 0.7% of the Australian sharemarket’s total capitalisation.

And it’s also hard to argue markets are already grossly overvalued in any case. Indeed, in both Australia and the United States, while price-to-earnings equity valuations are at above average levels, they are broadly consistent with the very low level of global bond yields. America’s NASDAQ-100 Index, moreover, is still trading at below-average PE valuations. And as for the US market being top heavy, the share of US S&P 500 gains accounted for by the five largest stocks (tech giants Apple, Alphabet (the parent company of Google), Microsoft, Amazon and Facebook) has over the past year been around 25%, or only a little above the typical 20% contribution from the largest 5 stocks each year.

Of course, the rise in equity markets in recent years has been associated with growing demand for ETFs – but correlation does not imply causation. The main driver of equity market gains has been global recovery from the financial crisis, the rise of the tech giants, and extra-ordinary policy stimulus from the world’s central banks.

Given ETFs still account for only a relatively small share of overall stock market valuation, it also stands to reason they don’t make markets especially vulnerable to a market crash. What’s more, when and if market’s do eventually crash again, it’s likely panicked investors will be selling individual company shares and traditional actively managed mutual funds just as much as they’ll be selling ETFs.

Conclusion: don’t generalise!

All up, many of the concerns raised in this and my previous post about ETFs seems to reflect common misconceptions and fallacies. As they are open-ended funds, it’s wrong to judge the liquidity of ETFs by the traditional “on-screen” measures more relevant for close-ended listed investment companies and individual company shares. And although the growth of ETFs has been associated with the recent global equity bull market, correlation does not imply causation – there are good fundamental justifications for the rise in equity prices and ETFs don’t appear to have generated significant net-growth in investment demand.

Last, but not least, it’s important not to generalise. The terms “ETF” only describes an innovative managed fund product structure (passively managed, open-ended, and exchange traded) whereas the underlying investment exposure – and means of achieving that exposure – can differ widely. Just because some ETFs – especially in differently regulated offshore markets – may use derivatives to get investment exposure or invest in relatively illiquid underlying assets – does not mean they all do. And, for that matter, even if derivatives are used, that doesn’t mean there is anything wrong with these products!

As always, however, it is important for investors to do their research and know exactly what they are buying.