Features | Editorial | 10 Mins Read | by
Exchange Traded Funds are great. But the ETF industry has become obsessed with gimmicks. This is a wasted opportunity. There are a number of great ETF ideas that could be pursued.
Exchange Traded Funds (ETFs) trade on the stock market alongside shares. They are easy to understand and offer access to global markets.
Most ETFs are domiciled outside the UK, which means that they do not attract the 0.5% stamp duty on share purchases. You are also able to access ETFs on all the investment platforms.
Another advantage of ETFs is that they aren’t subject to uncapped platform fees on Hargreaves Lansdown or AJ Bell. This makes a significant difference if a client has a relatively large portfolio.
Open-end funds can be more complex that ETFs due to the different share classes on offer.
The key ETF advantages include
1) They are low cost
2) They allow for easy global diversification
3) They can be bought instantly (unlike open-end funds)
4) There is usually no 0.5% stamp duty on purchases
5) ETFs can be bought on all of the investment platforms
6) They can allow you to avoid uncapped platform fees
7) There is no active fund risk (i.e. key man risk, over confidence etc).
It is very easy to be critical of innovation in the financial services industry. But ETFs have been a fantastic development.
The first popular ETF was the State Street Global S&P 500 Trust ETF (known as SPDR but it trades under the ticker SPY). The fund currently has US$264bn under management - the buy and sell price spread is as low as 0.003%.
The ETF was launched in 1993 and heralded a revolution. If you had wanted to buy the US stock market before then it wasn’t easy.
UK investors wanting to buy the US stock market can purchase the iShares S&P 500 ETF (CSP1). It has £26 billion under management and the bid/ask spread can be as low as 5 basis points i.e. 0.05%.
So far so good when it comes to ETFs.
The S&P 500 ETF (CSP1) helps you buy into the US
The trouble is that a number of ETF providers have introduced bizarre products in an apparent attempt to gather assets. People will buy gimmicks, but gimmicks rarely stand the test of time.
In my view, ETF providers often try to add value by being “too clever by half.” The result is that many of them fall flat on their faces.
A good ETF is one that will perform well over the long-term. It can only do this if it is full of good stocks.
Good funds own good stocks and bad funds own bad stocks.
What seems to happen is that a new growth driver is seized upon. An ETF is then launched that appears to be well placed to benefit.
It is “first level thinking” (see Howard Marks - The Most Important Thing) to assume it will result in the underlying stocks doing well. The airline industry has seen considerable growth but airline stocks have not done well.
Stock compounders perform well for investors. They generate high returns, sustain high returns and realize high-return growth.
A fund will only perform well if it has a reasonable concentration stock compounders. There also needs to be relatively few blow-up stocks.
ETF creators seem to have forgotten the following maxim: growth without quality makes for a busy fool.
The two main ETF providers are Vanguard and iShares.
Vanguard is the original passive fund house and was created by the late and great John C. Bogle - see The Little Book of Common Sense Investing.
iShares is part of the world’s largest asset manager, BlackRock. Vanguard fund investors own the business while Blackrock is a listed public company.
The general view of John Bogle, and for the most part Vanguard, is that people should have plain vanilla passive funds. In other words, buy an S&P 500 tracker and ignore any ETF that claims it can beat it.
As a private company, iShares has been more willing to innovate. Some of the asset manager ETF's are excellent while others are questionable.
The smaller ETF providers seem to jump up and down in an effort to get attention. Some of their products are good but many are without merit.
Marketing or product-led?
Marketing people add value when they are focused on marketing.
The trouble starts when marketing people have a hand in future products. Or even the strategic direction of a company. Think Sony and the plethora of digital camera options it offers.
Companies that focus on making the best products win.
A good example is Apple Inc. After the launch of the iPhone, Steve Jobs was asked what this meant for Blackberry. He refused to be drawn and only stated that Apple is a product company.
In other words, Apple's focus was only on creating the best products. The rest is history.
The joke when it comes to marketing led innovation relates to transport. If you had asked people in the nineteenth century what they want they might say: 'a faster horse.'
Put the product people in charge and you may just get the motorcar. Given the plethora of gimmick ETFs it appears that the marketing people are in charge of the industry.
Gimmick central: BRIC ETF
A classic gimmick ETF is the iShares BRIC 50 (BRIC) ETF (£215 million under management). BRIC stands for Brazil, Russia, India and China. The ETF invests in the largest companies in these countries.
Why? Former Goldman Sachs economist Jim O’Neil coined the term BRIC in 2001. The four countries were forecast to deliver strong economic growth.
The hope was that this would make their stock markets do well.
The BRIC ETF started life in June 2007 at £14 and today trades at almost £24 (the ETF distributes dividends). This is not a disaster. But no one checked if the stocks in the 50 BRIC stocks were any good.
Does this ETF only exist because it has a cute acronym?
Looking under the bonnet of the ETF and banks (regional and global) make up 45.2% of assets. The Oil & Gas sector makes up 24% of assets. These are mature and low return sectors that experience their fair share of stock blow-ups.
In my view, there is little logic to the BRIC ETF. It appears to have been built because it might sounds good and may sell well. The quality of the companies in the four countries is not high.
Largest companies in the BRIC ETF
Thematic ETFs appear to another example of first level thinking. Or perhaps more accurately, creating a product that might sell and that carries a relatively high fee.
For the record, I think iShares is a good ETF provider and product innovation can be helpful. For example iShares offers S&P 500 sector ETFs while Vanguard chooses not to do so.
Thematic ETFs from iShares include:
1) Automation & Robotics (RBTX) ETF 2) Digitalisation ETF (DGIT) 3) Digital Security ETF (LOCK), 3) S&P 500 Global Water ETF (IH2O) 4) Electric vehicles and driving technology (ECAR) 5) Ageing Population (AGES).
These themes are all well and good. The question is whether the underlying companies are any good. The same issue impacting the BRIC ETF back.
The iShares Automation & Robotics (RBTX) has £1.4 billion under management and charges 0.4% (£5.6m in annual fees). It is questionable whether any of these thematic ETFs add long-term value over an S&P 500 ETF charging 0.07%.
iShares Automation & Robotics ETF versus S&P 500 ETF
Digitalisation ETF versus the S&P 500 ETF
Every day, a new ETF seems to come along. Bloomberg even speculated that we might see an Avocado ETF at some point. An odd recent ETF is one focused on companies that are aligned with US Republican voters. The ticker? MAGA.
There are also lots of leverage share ETFs and commodity ETFs.
Source: ETF data
More good ETFs please
The motto of Fund Hunter is pretty simple: good funds own good stocks.
Instead of creating gimmick, the ETF industry should create ETFs with good companies that will perform well.
What kind of ETFs should be developed? The primary focus should be to develop ETFs with stock compounders. This will enable them to perform well over the long-term.
Below are some possible ideas for ETFs that may actually be good. You're welcome.
The payment sector is one of the most attractive sectors to invest in. There are two payment ETFs available in the United States and none in the UK.
I’m not sure on either of the US payment ETFs: IPAY and TPAY. If I had to choose I would probably look at IPAY at the current time. In any event I would prefer to own a UK listed payment ETF.
The two US listed payment ETFs
Source: ETF data
Companies that operate payment networks have been attractive investments. The larger they become the more more users they attract. Consumers and companies want to be with the payment network that is most useful payment network.
The network effect keeps the competition at bay and helps drive growth. The payment sector is also one that is subject to long-term growth as we move away from cash.
A payment ETF should, in my view, ignore companies selling payment-processing systems or products with credit risk i.e. credit cards. The main payment network companies are Visa, MasterCard and PayPal.
Visa has been an investor pleaser
Surely there is a case for an ETF with payment network companies? Preferably market cap weighted and accumulation. It should be possible to offer an ETF like this in an inexpensive manner.
Most ETF companies try to make things over complex to “add value.” In my view, it is best to keep things simple. I am also not sure of the merits of ETFs when they charge over 50 basis points (0.5%).
The total expensive ratio on the actively managed Scottish Mortgage Investment Trust (SMT) is 0.37%.
The way most ETFs try to capture quality/growth doesn’t work. It tries to be too clever by looking at historic financial metrics. The trouble is that things can, and do, change.
The proof is in the pudding. The iShares MSCI World Quality Factor ETF (IWFQ) has delivered a similar result to the iShares MSCI World ETF.
It is a similar story if we look at other factor ETFs.
The following ETFs - Vanguard Value Factor ETF, the Vanguard Momentum Factor ETF, the Vanguard Minimum Volatility ETF and the Vanguard Liquidity ETF - have not shown a significant divergence versus the MSCI World ETF since December 2015.
A quality ETF is only just ahead of the index
A simple sector driven approach is one alternative. This means that we exclude low quality and mature sectors. We might also exclude companies that meet these criteria.
If we take the S&P 500 we can exclude the Real Estate, Utilities, Materials and Energy sectors straight away. We can also exclude banks and any other companies exposed to credit risk such as credit card businesses.
This kind of approach might also be useful on other blue-chip indices and potentially small cap indices. The Russell 2000 index of smaller US companies, for example, has a heavy weighting in regional banks.
iShares S&P 500 ETF sectors
ETFs have the potential to be great. It is a shame we have seen the ETF industry launch a host of gimmicks. A MAGA ETF is unlikely to make ETFs investing great again. A Trade War ETF just seems bizarre.
The irony is that ETF companies would do best long-term by creating good products – ETFs that will perform well long-term. There is no point creating an ETF that will underperform the S&P 500 index and/or the MSCI World index.
I have made a few suggestions and there is plenty more where that came from. Let's move on from gimmicks and make ETF’s great again.
ETF Industry – call me.