The positive attributes of exchange-traded products are straightforward: they are low-cost, liquid, and transparent.
A hand-scribbled list of these selling points would occupy at most one half of the back of an average-sized business card. Meanwhile, negative headlines about ETPs continue to take up a vast amount of space in the popular and financial press. But is this disproportionately-large share of negative ink reflective of the broader experience of investing in ETPs? I think not.
I am not trying to trivialise the importance of understanding the structural risks associated with ETPs as well as those present in the broader ETP ecosystem (the exchanges, post-trade clearing and settlement). I continue to believe that education is paramount and that it will be a critical precursor to more widespread adoption of these products. After all, the golden rule of investing in ETPs--and any investment vehicle for that matter--is to know what you own.
But increasingly, it seems that bad headlines have been keeping many investors from realising the big picture benefits that ETPs offer, and preventing them from putting their associated risks into proper perspective. The average investor experience with ETPs (the overwhelming majority of ETP assets are in straightforward equity, fixed interest, and commodity-related products) has been and will no doubt continue to be marked more by enjoying low-cost exposure to a broad-based passive benchmark, than by adverse encounters with misunderstood commodity, leveraged, or volatility-linked products.
Countless studies have shown that costs are the single greatest predictor of fund performance--lower costs tend to lead to better post-expense performance. On this front, most ETPs have a clear advantage over traditional funds - both active and passive alike. Morningstar data shows that the average total expense ratio for those exchange-traded funds listed on the London Stock Exchange that track the FTSE 100 index is 0.31%. The average TER across all European ETFs tracking equity benchmarks is 0.46%. These figures compare very favourably to the average TER for traditional European equity funds tracking passive benchmarks (0.91%) and even more so to actively managed European equity funds (1.80%). These already large differences in carrying costs will only compound over time. Furthermore, competition among ETP providers has and will likely continue to drive down expense ratios. This will become increasingly feasible as ETP assets continue to grow and providers in turn share efficiencies of scale with fund holders in the form of lower expense ratios in an effort to fend off competitors.
While the on-exchange liquidity of many ETPs is still fairly thin, the trend is undeniably positive. As of the end of September, aggregate ETP trading volume on the LSE had increased nearly 44% on a year-to-date basis. I think that this increase in on-exchange trading is a virtuous circle--liquidity will beget more liquidity--to the benefit of all ETP investors. Larger volumes will inevitably increase the level of competition among market makers, and bid-offer spreads (a crucial component of the total cost of ETP ownership) will become increasingly narrow.
Transparency is also improving. Though there remain some shadowy corners that could use some light--most notably with regards to the underlying swap costs in synthetic funds and collateral policies and counterparties in those physical replication funds that engage in securities lending--most ETPs have been fairly transparent from the very beginning. Each of the major providers of swap-based ETFs now provides daily disclosure of the composition of their funds’ substitute-collateral baskets. This level and frequency of disclosure allows investors to make better-informed decisions, giving them the information they need to assess the amount of risk they are assuming and the level and quality of protective measures put in place by the providers. Meanwhile, iShares has just begun disclosing the details of its securities’ lending activities within its physical replication funds on a daily basis. In doing so, they have set a new standard for transparency in physical replication funds. These have been welcome developments, representative of providers’ commitment to fuller transparency. Furthermore, these actions have only served to widen the ‘transparency gap’ between ETPs, traditional funds, and other managed investment products.
I do not intend to gloss over the issues that remain within the ETP ecosystem. There will always be room to improve the investor experience. But it seems though some of ETPs’ best features are being missed as their real and potential weakness have been put under the microscope. It might be time to take a step back and have another look at the big picture. ETP assets have grown at a breakneck pace over recent years for good reason. These products are low cost, liquid, and transparent and improving in all three aspects over time.
This article was first written by Morningstar for FTAdviser in September 2011.
