Electronic Traded Funds are the Future of the Market

Electronic Traded Funds are the future of the Market

Will Mutual funds be able to survive in Developed markets like US.

With their low costs and tax-friendly trading, ETFs have transformed US markets and are taking over other developed markets with this the popularity of this is increasing in the emerging markets

Stock markets have a new purpose. Once devoted to trading stocks and setting their prices, they are now the venue for buying and selling something other than shares: exchange traded funds.

ETFs are taking over markets. Shares in Apple, the world’s biggest and most heavily traded company, turn over more than $3bn each day. But that is dwarfed by the biggest ETF, State Street’s SPDR S&P 500, which trades more than $14bn each day. Five of the world’s seven most heavily traded equity securities are ETF's.

From a modest beginning, ETF's impact on stock trading has now reached mammoth proportions, and ETF's now account for nearly one-half of all trading in US stocks and may other developed markets have a large percentage of trade via these funds. It is not just in trading that ETF's dominate. Their assets under management were negligible 20 years ago, but now exceed $3 trillion. They hog flows of new money and are revolutionizing the business of long term saving, once led by traditional mutual fund groups. Over the past 12 months, $130.7bn has flowed out of all US mutual funds, while $240bn has flowed into US ETF's.

In my opinion they are the structure that people will use to get exposure to securities in future, and mutual funds will be banished to the dustbin, like typewriters have been replaced by computers. It’s just a better technology and so it will come to replace funds over the next 20 years.

Both mutual funds and ETF's are collections of securities packaged into a fund. Almost all ETF's track an index, like passive index tracking mutual funds. The difference is that mutual funds are open-ended investors can pay directly into the fund or withdraw from it. This is done once a day, at prices set at the close of trade. With an ETF, investors buy and sell shares without directly adding to or taking away from the fund itself. Instead, the shares trade on an exchange and market makers buy, sell and create new shares to ensure they move in line with the value of the fund.

The advantages, as far as investors are concerned, are twofold. First, they can buy or sell at any time of the trading day, at the latest price. Second, the fund itself bears fewer costs. And in the US there is a third advantage: ETFs’ tax position is superior. Once such provisions are available in other developed and developing markets the net overall yield on such funds would increase and there by the popularity would increase any fold.

Yet as ETF's have grown, so have the worries about them. Could ETF's dominance create new systemic risks, or trigger another market crisis? Because the securities they hold are often not as liquid as the ETF itself, there are risks of mismatches and forced sales.

The idea that they have underlying liquidity, seemingly whatever the asset, was always a rather dangerous one, and as they grow ever bigger I would suggest this is something regulators might like to look at, especially in a market like India where the market regulator SEBI is very conservative and the overall penetration of the equity markets on the whole is not very large having a limited market depth.

However, the ETF structure has now survived several bursts of market turbulence without causing system wide problems, and they may in any case not yet be big enough to have a systemic impact.  ETF's still have less than 5 per cent of the total investment universe, when measured by the assets they manage.

By themselves, ETF's do not as yet have the critical mass to kick-start a systemic crisis, in my opinion.  But I strongly feel that they do have the ingredients to create a snowball effect, once markets go south decisively. They do appear to lead markets now, rather than mirror them.

Since the financial crisis, markets have been dominated by politics and attempts to second guess central banks. By allowing investors to make focused bets on sectors or asset classes with the click of a mouse, ETF's have made this kind of trading much easier.

ETF's have been a very efficient way to play these themes that are running in the market at present and an overall broad play on such themes is easier to execute by the EFT structure, which are trickier for stock pickers. But whether ETF's have been behind these trends is open to question. Preliminary evidence from the remarkable market action that followed Donald Trump’s election in the US, which saw sharp moves upward for stocks and downward for bonds, suggests that ETF's may indeed be encouraging short-term movements. Since the election have already been enough to make it “the most concentrated asset allocation shift in history.

In the two weeks between the November 8 election and the Thanksgiving holiday, about $50bn flooded into equity ETF's while roughly as much capital abandoned fixed income funds. In the past, investors would have needed to pause to think through which of their stocks might be most affected. Now, ETF's allow them to make sweeping bets on sectors at the press of a button.

About 20 per cent of equity flows went into the financial sector alone in just 12 trading days. The market values of two ETF's that cover only financial stocks rose by 46.5 per cent and 31 per cent respectively.

This buying will have raised all the stocks in the index tracked by the ETF's equally. That implies that some of the weaker banks will now be under priced, while others are overvalued.

With this kind of flow and money flowing in EFT’s there’s little opportunity for people who are looking at a stock from the bottom up, rather than the top down from an ETF, in my opinion.  It makes the large stocks in the ETF's very inefficient because you get a constant inflow to the companies in the index.

Stocks now tend to move close in alignment with each other most of the time, and then divert sharply in response to corporate announcements. News has always had an impact on stocks, but this pattern has grown far more pronounced since the advent of ETF's,

The flow of ETF's will mask any issues in a big company’s business. The flow from ETF's into IBM, for example, is more appealing to investors than IBM’s business. Therefore you get greater reactions to corporate announcements whenever they happen.

This trend of rising correlations has serious consequences for active stock pickers, who will select bargains and then find that their stocks stay cheap.

Combined with the swift moves in markets, this has created an environment in which active investors have persistently under performed since the crisis. Clients have punished them for this, with some $336bn flowing out of US active funds in the past 12 months.

It also makes it harder for smaller companies to raise capital. Investors moving money through ETF's tend to put capital into the biggest companies with the biggest weight in the index. Others go without.

In particularly in relatively ill liquid and inefficient markets such as some emerging markets the fast turnover can create problems especially in markets like India where the overall market depth is limited and even though there are around 6,000 companies listed on the nationwide exchanges the market of which market depth is really present only it the top 500 companies out that 12 per cent of a typical stock turns over each year, compared with 880 per cent turnover for ETF's.

ETF, run by some major funds like Black Rock, turns over some $2.6bn each day, more than any individual stock bar Apple. Emerging markets tend to be dominated by a few large, partially state controlled companies, which automatically receive a large chunk of ETF money because of their weight in the index. Capital is hard to find for smaller companies which may otherwise look more attractive. This has led active managers to allege that the rise of ETF's and passive investing are making markets less efficient.

 In my opinion indexing increases as a proportion of assets, correlations between stocks do increase. Stock markets aren’t where capital gets allocated. It gets allocated in IPOs [initial public offerings] and secondary offerings.

Another area of concern is a change in the ownership structure of companies. ETF's and passive mutual funds are primarily taking business from actively managed mutual funds, which are the bedrock of the way people around the world save for retirement. Planned regulatory changes in the US are likely to accelerate the trend by pushing brokers towards selling lower price funds which means ETF's and passive mutual funds.

ETF's are a scale business and they work on economies of scale.  The more money they can attract, the lower the costs and the higher the profit margins  meaning that a few companies, all based in the US, have come to dominate. The top three hold more than 69 per cent of all ETF assets, or more than $2.3tn, between them. BlackRock, the world’s largest fund manager, is by far the dominant ETF provider, followed by Vanguard and State Street. These companies are now leading shareholders in virtually every large public company on the planet.

Active managers traditionally take a vocal role in corporate governance, and complain that this will no longer happen under ETF's a charge that the largest ETF issuers indignantly deny, saying that they can only protect their interests by taking an aggressive attitude to corporate governance.

But it is undeniable that the ETF revolution has left corporate ownership far more concentrated. The responsibilities of stewardship and overseeing corporate directors have been ceded to a few large companies.

Against this, they have opened up assets such as bank loans or emerging markets or commodities to retail investors, and even to institutions, that were effectively closed before. Gold, for example, is now far easier to trade, without the need to take possession of gold coins and guard them. Some $27bn in shares in the largest gold ETF change hands every day. And they have certainly brought down costs for investors.

It is clear that ETF's are bringing more liquidity and transparency to savers and that they are enabling small savers to invest at a very low cost, in my opinion.

From a modest beginning, ETF's impact on stock trading has now reached mammoth proportions, ETF's are just a better technology and so they will come to replace mutual funds over the next 20 years

_ Farzan Ghadially