Debunking The Myths Of ETFs
Finance Tips Here’s how exchange traded funds can diversify and increase the value of your investment portfolios.
ETFs have become the foundation of many clients’ investment portfolios, and while many benefits are understood, like any new product, there are misconceptions that have entered client conversations. Below are some common misconceptions about ETFs that need to be addressed:
ETFs trade on an exchange; however, unlike a stock, which has a limited number of shares available for sale or purchase, an ETF is an open-ended fund that can create new units based on demand. This means that clients can buy larger blocks of units without worrying about running through the order book, while clients that buy smaller blocks will benefit through offsetting client orders. Market makers will continually offer new shares and will create new units when needed.
Active management has an important part to play in financial markets and can deliver meaningful outperformance; the challenge for active managers is to do so consistently over time. Active managers typically target improved risk adjusted returns by selecting high quality stocks, ETFs can outperform when the entire market lifts off, or when higher fees and adverse stock selection impacts active managers.
ETF liquidity begins with the underlying portfolio, where ETFs that are based on harder to trade strategies will then have less liquidity. An ETF adds liquidity through exchange trading, where as an ETF matures more buyers and sellers meet on the exchange and the ETF develops more liquidity than its underlying portfolio. This is particularly beneficial in narrower asset classes and fixed income, areas with historical liquidity challenges.
Warnings that ETFs will cause instability — particularly in less liquid areas like bonds — is a consistent refrain. Instead, I would turn this misconception on its head. While fixed income market reforms have impacted liquidity and execution, ETFs add liquidity because they hold a diversified portfolio, and because most of the trading on mature ETFs does not touch the underlying portfolio. As an example, on our High Yield Bond ETF (ticker: ZHY), a harder to access asset class, only 17 percent of the exchange trades in 2016 resulted in underlying portfolio trades. This percentage would only be lower on larger U.S. listed ETFs.
An important caveat to exchange trading is that, just like a stock, an ETF is subject to the integrity of the markets. In other words, if there is a market event or large moves in investor sentiment, we should expect ETFs to move with the market. ETFs are priced based on their underlying portfolios, not the other way around. The assumption that ETFs continue to drive market instability — as they did when they became prominent — doesn’t pass the smell test.