Investors who allocate their money to ETFs for the long term are not making the best potential use of their capital, says Rathbones’ David Coombs, who believes index-tracking products are becoming so complicated that they are creating market risks. 
Exchange-traded funds (ETFs) have witnessed exponential growth over recent years. Back in 2005, global ETF assets amounted to just $417bn but this had reached $4.4trn by the end of September 2017, according to Ernst & Young, before passing the $5trn mark in early 2018.
In its Global ETF Research 2017 report, Ernst & Young said that ETF assets have the potential to hit $7.6t within three years. “It seems that almost every trend that has shaped investment markets in recent years has worked in favour of ETFs,” the consultancy explained.
“This includes global themes such as the shift to self-directed retirement saving; economic factors such as low yields; regulatory efforts around suitability and value for money; technological developments such as digital distribution; and investment themes such as the ‘shift to passive’.”
The future growth of global ETFs
Source: Ernst & Young
But Coombs (pictured), head of multi-asset investments at Rathbones and manager of funds such as the £275m Rathbone Total Return Portfolio, said the move towards passives could herald a host of market problems – especially if more complex products such as ETFs of ETFs gain traction.
“This is not an evangelical anti-passives thing, let me be very clear about that,” he explained. “I am concerned about the massive increase in the use of ETFs and the effect that has on the efficient allocation of capital over the long term, as well as on market liquidity and trading.
“I see ETFs as playing a really important role in portfolio construction, in terms of managing tactical risk, but as a long-term investor I feel you are wasting your capital by investing in ETFs. Why invest in the bottom 50-performing companies of, say, the FTSE 100?”
If an investor can hold just the top 50 companies of an index like the FTSE 100, then it is obvious that they will outperform those that are forced to own the bottom 50 as well. Coombs conceded that it is by no means certain an active investor will be able to do this; however, he questions why anyone would go into an investment knowing that they are guaranteed to buy the worst companies in an index.
The use of index trackers as the principle tool of investment goes against an important element of investing, according to Coombs. That is, capital should be allocated to the companies that will make the best use of it and not be channelled towards those that will deploy it inefficiently.
“With an ETF, you don’t get so much of the interaction with company management and you don’t get that push on management to do the right thing. Capital should, in my view, flow to those who make the best use of it. By just investing long term in ETFs, you’re pushing against that basic pillar of how capitalism works. With passives, capital falls to those that don’t deserve it,” the fund manager argued.
“This isn’t a defence of poor active management. But active management isn’t just about outperforming: active management is about ensuring that company managements do the right thing and use the capital that they are given appropriately. It’s monitored, reviewed and shares are sold if companies aren’t doing this properly.
“That’s just my view of how investing, in any asset, should work. Good companies get the capital they need so they can then generate better returns by investing it wisely or paying it back to shareholders in some way. On the other hand, capital should be restricted for those companies that won’t use it appropriately.”
Coombs added that this problem is compounded when we get into the realms of ETFs of ETFs, or – as the name would suggest – ETFs that track other ETFs rather than an underlying stock, bond, or index.
While this structure has not yet been seen in the UK, a number have been launched in the US. Earlier this year, Ocean Capital Advisors listed a global macro ETF of ETFs that uses artificial intelligence to allocate to single-country ETFs; providers such as Vanguard and Deutsche Asset Management also have products that are ETFs of ETFs.
Conscious that it could just be a matter of time before such products are listed in the UK, Coombs said: “An ETF of ETFs is kind of gearing this problem up and making the investor even more remote from company management teams. For me, that doesn’t sound like a good thing and I am fundamentally against them.”
One of the multi-asset manager’s concerns with ETF of ETFs is that, like other non-mainstream offerings such as smart beta or leveraged short ETFs, represent an unnecessary complication of the initial aim to simply track the performance of an asset or index.
“The minute you moved away from pure ‘delta one’ index tracking, someone is making a decision – and that’s not passive,” he argued.
“Whether that’s an algorithm, a basic quant strategy, smart beta or an individual, then you are active. It may be limited active but there’s element of active there. Someone is building an algorithm, coming up with a quant strategy or setting an asset allocation that will remain static after a one-time call.”
“The minute you include any of those factors, you are bringing in biases and the potential for error, which goes away from what passive investment was supposed to be.”
Another problem with complicated varieties of ETFs, according to Coombs, is a greater likelihood that they will be bought by “tourist investors” who pick them up when they are interesting new stories but drop them as soon as any problems emerge.
This means that even genuine long-term investors in these products will be hit hard as more flighty investors sell them. “One of the biggest risks of investing is who you are investing alongside,” Coombs said. “With ETFs, you tend not be holding alongside other investors who have made a conscious buy decision. That’s quite a difficult place to be.”
At the end of the day, however, even the more complex ETFs tend to be cheaper than actively-managed strategies and, as most ETFs have yet to be really tested by a serious market downturn, this can trump the perceived benefits of more expensive active management.
“Unfortunately, the debate has become dominated by cost and by this fundamental, almost religious conviction that active managers are overpaid and underperform,” Coombs concluded.
“The reality is that there are some active managers that are overpaid and underperform but there are also some active managers that given enough time will most likely generate surplus returns for patient investors.”