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Why ETFs have got too big for their boots

Why ETFs have got too big for their boots

ETFs were originally designed to be cheap and easy to understand, but with new launches happening every day, is the asset sticking to its principles or have ETFs got too big for their boots? One investment professional discusses how he uses ETFs to his advantage.

Selector: Christophe Magnin

Company: Hinduja Bank

ETFs were initially designed to be cheap and simple to understand, but with thousands to choose from this description is no longer valid for all products.

We are also not convinced that adding layers of sophistication and complexity will bring added value or generate extra returns. We feel that some of these products are being designed simply to capture part of the massive inflows into passive funds.

In the future, ETF providers should consider the voting rights of underlying stocks more closely. As ESG criteria become more important for investors, ETF managers should systematically execute the voting rights they are accumulating to improve corporate governance.

Fashionable favourites

We are closely monitoring the evolution of the passives industry, but are still heavily reliant on active managers. We may use ETFs more in the future but as many of these products are new, we want to make sure they will be able to respond to our clients’ needs over a full market cycle.

For example, we have not followed the fashionable move into bond ETFs yet, due to some question marks over the liquidity of the underlying basket of bonds compared with the intra-day liquidity of the ETF.

Currently, we mainly use passive investment vehicles as short-term market timing strategies. We may use ETFs of well-known indices to gain exposure to particular markets in case of an exaggerated correction on a country, sector or certain commodities. In addition to tactical bets, we also recommend ETFs as a way to build core equity positions for clients who look for market-like performance.

Active underperformance

We cannot ignore the underperformance of large-cap US active funds compared with the S&P 500. Almost nine out of 10 funds underperform the index over three, five or 10 years. Nevertheless, US active strategies can still make sense depending on the risk profile of the client.

For instance, if an investor is looking for a strategy with reduced drawdowns, an ETF will, by definition, be inappropriate.
We have also noticed that some stocks tend to be overvalued because of the increasing share of passive funds that purchase stocks without considering the fundamentals.

From an investor’s perspective when there is mispricing, an investment case appears.

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

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