Christopher Niesche: Rise of exchange traded funds threat to fund managers

Day traders, short sellers and tech investors usually hog the headlines in the investing and share market pages, but one investment category has been quietly surging over the past year — the exchange traded fund.

Australian investors now hold almost A$103 billion ($111.7b) in local exchange traded funds, having added A$8b to their holdings in the first quarter of 2021.

In the 12 months ended March 31 investors poured a record A$46b into ETFs as they poured cash into the investment vehicles during the coronavirus pandemic.

ETFs are shares that contain a collection of securities and track an underlying index or investment theme. For instance, an ASX-200 ETF would have every share in the 200 index in it, in proportion to their weighting in the index. The fund is then chopped up into individual shares that investors can buy and sell on the stock market like any other shares. Many also pay dividends.

Betashares, one of the major issuers of ETFs, estimates that investors will add another A$25bby the end of the year.

As investors pour money into ETFs, the investment trend marks a major challenge to the existing fund management industry.

Rather than relying on fund managers and star stock pickers to select winners, investors are happy to put their money into these passive investments, with fees of only a fraction of traditional fund managers’.

Given the majority of active fund managers underperform the index or, if they do outperform, the premium often isn’t enough to justify their fees, ETFs are proving highly popular.

Young investors in particular are piling into them, in a trend that does not augur well for the funds management sector in the coming years as they amass more cash to invest and their superannuation balances grow.

ETFs don’t just track share market indices; they come in all manner of flavours and many investors like they way they can easily tap into megatrends in the global economy.

For instance, they might buy a Chinese tech ETF, consisting entirely of Chinese tech stocks. By simply buying some of the EFT on the Australian stock exchange they have diversified access to a range of stocks in a sector they would otherwise struggle to buy.

Investors have a world of choice. There are renewable energy ETFs; Nasdaq and Dow Jones ETFs; ETFs that invest in healthcare stocks or goldminers; and others which invest in bonds. They can also choose EFTs that meet social or environmental considerations.

And ominously for the funds management sector — they can do all of this without needing to put money into an investment fund as they would have in the past. An investor could cheaply construct a portfolio of ASX200 stocks, some Nasdaq, corporate bonds and a bit of emerging markets. Young investors also see diversified ETFs as an alternative to bank savings and term deposits, which are currently paying interest rates so low as to not be worth the bother.

For many years ETFs had been derided as a trend that would cause the next global financial crisis. They were artificially pushing up stock prices, particularly of larger companies,and once investorsbecame nervous about the state of the markets, they would quickly withdraw their funds, causing an almighty market crash.

There were also concerns about bond markets — mum and dad investors would withdraw their money from fixed-income EFTs, leaving funds with hard to sell bonds, once again causing a crash. Both of these scenarios turned out to be nonsense.

Share markets and bond markets both suffered huge disruptions in March last year as the pandemic forced the shutdown of the global economy, and markets easily digested the extra volumes of ETFs being offloaded. This is not to say ETFs are without risk. As they become more exotic some are pushing into illiquid markets and losing one of their chief benefits,leaving investors with the risk they might not easily be able to exit their investment.

Another nascent trend overseas which has not yet hit Australia is for leveraged ETFs, which borrow money to invest. Like all leveraged investments, these can magnify gains but also magnify losses.

These potential problems aside, ETFs look set to continue growing.

For the funds management sector, this presents a huge challenge.

As Australians’ superannuation balances have risen steadily over the past three decades, fund managers have lazily creamed a couple of per cent off the top. That’s a huge amount of money when it comes to the A$2.7bthe nation collectively has in superannuation.

The investment management sector will have to find a way to convince consumers that paying perhaps 2 per cent of their investment in rather than as little as a tenth of that is value for money. It won’t be easy.

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