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ETFs could be 'accident waiting to happen', warns selector

ETFs could be 'accident waiting to happen', warns selector

The creation and rising popularity of ETFS is ramping up the pressure on active managers, but does growing sophistication in the asset class come with a risk? One investment professional discusses how he uses ETFs to his advantage.

Selector: Caron Bastianpillai

Company: Notz Stucki & Cie

It comes as no surprise that ETFs have surpassed hedge funds in terms of total assets under management since the end of 2015, as they have become increasingly competitive in terms of pricing. Performance is all about having the right asset allocation and timing, the latter being more difficult to achieve on a consistent basis.

Passives have now become widely used to gain low-cost market exposure to specific markets, across different asset classes, or specific sectors.

Given the influence of macro factors, politics and central bank rhetoric on market moves in recent years, we have increasingly played various sector themes within our asset allocation via passives on a tactical basis or country themes, most notably Japan.

ETFs for short-term plays

There have been numerous studies produced by the likes of S&P Global, highlighting the fact that more than 70% of equity managers underperform their benchmark net of fees over 10 years. The record is far worse for investment grade bond fund managers.

With a growing number of competitors within the investment community chasing the same opportunities, particularly in the US, it has become increasingly difficult to generate alpha. In the case of emerging markets, stock price movements tend to be driven by macro, political or other unforeseen events rather than corporate fundamentals so you need to act fast.

Given the time and effort in identifying country-specific emerging market managers, it makes more sense to invest in an ETF in the case of a short-term or tactical play. India, Argentina and Brazil are the latest examples of where changes on the political front have sparked significant rallies in their respective equity markets, all based on the hope of a better future.

A fashionable cocktail

During the past decade, JP Morgan estimates that passives and quants have increased market share from less than 30% to around 60%. In the face of this trend, active managers are struggling to compete in terms of operating expenses.

Together with trend-following CTAs and the more fashionable cocktail of risk premia strategies out there, which will tend to sell equities in a market downfall, the wake-up call could be deadly.

ETFs have clearly become more complex over the years and given the low levels in the VIX, leverage has increased in the aforementioned range of products. Creativity has no limits but could also be an accident waiting to happen.

This article originally appeared in the September edition of the Citywire Selector magazine. 

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