Home / Opinion / The envelope tested further: ETF issuers get ever-more creative

ETFs have revolutionised the investing universe for many good reasons. But ultimately ETFs are just like stocks - there are the good, the bad and the ugly.

From humble beginnings in August 2001, when State Street Global Advisors listed three funds tracking the ASX top 50 companies, the top 200 companies and the top 200 listed property entities, worth $48 million in total, exchange-traded funds (ETFs) have swelled to a $130 billion sector featuring more than 260 different listed products.

Australian exchange-traded product growth is just a small part of the global ETF behemoth. According to ETF.com data, assets in ETFs have grown by 85 per cent in just the last five years to US$5.95 trillion ($9.4 trillion), from US$3.4 trillion at the end of 2017.

The primary reason for the growth is the fact that the ETF is a very simple investment product that provides investors the index return, minus relatively low fees. If that index is the S&P 500, for example, then in one ASX trade you can ‘buy’ the performance of the US stock market. Highly liquid and much cheaper than actively managed funds, ETF’s have seen captured the hearts and minds of investors the world over.

One of the original selling point for ETFs was that active management ran a huge risk of under-performing the index, which the ETF could never do – because it was the index. And from that flowed the concept that, in any asset class, the index return was the return to which investors were entitled – further discrediting any active managers that could not deliver it. Why bother with active managers when you could just buy the index through an ETF, for less management cost?

There are criticisms, however. In an equity ETF you own the index’s star performers, but you also own its dogs; there is no fundamental analysis involved, although over time, the higher-quality companies that do well in their business are typically the survivors that prosper and as such, are rewarded with higher market capitalisations, and tend to grow to assume the leading positions in the index.

But that is in the long run – over shorter timeframes, the index can be dominated by the awarding, by investors, of huge market capitalisations that may not reflect fundamental business strength. For example, when inflation started to rear its ugly head earlier this year, and interest rates suddenly turned upward in response, the big US tech stocks suddenly looked very exposed and over-valued – and the short-term reckoning, both for the stock indices they had come to dominate, and investors in the ETFs based on those indices, has been brutal.

Similarly, bond ETFs have given investors instant diversification into global fixed-income markets, based on bond indices; while that can certainly be useful to investors, there are potential problems. For example, it is bond issuance that decides weightings in the ETF portfolios.

There are always criticisms of liquidity mismatches, and potential liquidity problems in market downturns – but in practice, the broad-based ETFs have largely come through these tests with flying colours.

If there is a major potential problem with ETFs, it is that the concept has been broadened massively in scope, well away from the original idea of a traded vehicle that blandly tracked established stock indices.

Now, an entire industry of index providers has developed to build highly specific indices. ETF issuers which want to target a particular theme, or industry, or investment exposure, can get an index built to reflect that and then construct an ETF around it. ETFs get ever-more-specific, which is great for investors who want highly targeted exposures – for example, to the battery metals that drive the clean energy and electric vehicle (EV) revolutions – and who are happy to pay the higher cost for these bespoke vehicles.

There are even ‘active’ ETFs, encompassing portfolios selected by a professional fund manager with the objective of outperforming the market benchmark, not just tracking it.

In the US ETF issuers are highly entrepreneurial, knowing that somewhere, someone will likely want to buy anything they issue. There are ‘sin’ ETFs, marketed as holding the stocks that ESG-oriented investors won’t buy. Recently, issuers in the US have also offered ‘anti-woke’ ETFs invest in politically conservative causes. There is even a MAGA (Make America Great Again) America First ETF, that allows punters to invest in companies that align with Republican political beliefs (it is tiny, at just US$13.7 million).

One issuer, Tuttle Capital Management, has launched an ETF that short-sells anything owned by celebrity ‘green’ fund manager Cathie Wood’s flagship strategy, the Ark Innovation ETF, and has followed that up with the Inverse Cramer, an ETF that short-sells any stock favourably mentioned by celebrity analyst Jim Cramer of CNBC’s Mad Money program. Twitter netizens have regularly complained that Cramer is the kiss of death for stocks: Tuttle has given them a vehicle that actions this view. To be fair, though, Tuttle has hedged its bets with a Long Cramer ETF that buys the stocks over which Cramer enthuses.

That is a bit of fun – and it is not yet a feature of the Australian ETF market – but it is also a long way removed from a simple tradeable vehicle that tracks a major asset-class index. As always, it is up to the investor to do their homework on ETFs.