Exchange Traded Instruments Are Here to Stay

There’s a multitude of reasons as to why exchange-traded instruments are bought and sold at a high clip but like with every single aspect of life, there’s always two sides to it.

ETFs come with their own set of challenges and it is an area we will be keeping an eye on as it develops.

It would be rude not to start this article with a definition: “Exchange-traded products (ETP) are types of securities that track underlying security, index, or financial instrument.”

In plain terms, the fund usually mirrors a basket of securities or stocks commodities on the stock exchange without the need to trade individual instruments. Got the formalities out of the way? Great. Now, let’s cut to the chase.

ETFs have been around for quite some time but in recent years, the financial and trading landscape seems to be changing in their favor, making them a more prominent option for both individual and institutional investors.

This is not merely conjectured as according to a recent research paper by leading specialist business and technology consultancy, Goodacre UK “Assets under management of ETFs have grown rapidly in the last ten years, from $800 billion in 2008 to $5 trillion in May 2018.”

There’s a multitude of reasons as to why exchange-traded instruments are bought and sold at a high clip but like with every single aspect of life, there’s always two sides to it. ETFs come with their own set of challenges and it is an area we will be keeping an eye on as it develops.

ETFs vs Other Funds: What Makes ETFs More Attractive?

“There is a lot in common between electric guitars and exchange-traded funds [ETFs],” according to Martin Small, BlackRock’s Head of US iShares. Now that’s quite the simile. One to make you scratch your head.

What is Mr. Small referring to when he’s drawing the comparison between ETFs and electric guitars?

The fact that ETFs offer investors unparalleled latitude in the way they construct their portfolios, similar to how the chord combinations of the electric guitar changed music as we know it.

ETFs are hybrid products that combine the best of two worlds: the pros of open ended-funds, like mutual funds, as well as the pliability and Liquidity of closed-ended funds, like the stock exchange.

They offer investors the ability to diversify their portfolio and minimize exposure and risk associated with their investment.

Like we mentioned before, there are a lot of reasons as to why these funds started gaining steam amongst investors.

Firstly, you need to look at the cost. ETFs won’t break an investor’s wallet as they are associated with low fees. The reason behind the low fees lays in that ETFs are considered passive investments.

What that means is that there is no need to pay a fund manager to manage the fund and engage in aggressive and regular trading to beat the market.

Portfolio diversification and low fees are important but if they would mean nothing without transparency.

Unlike other funds that can only be bought or sold at the end of a trading day, ETFs can be traded anytime within normal trading hours and hold open-market rates.

With stocks being a prominent asset within an ETF you’re immediately exposed to unambiguous practices.

Stock market transactions are very transparent because prices are made available to the public throughout the day.

ETF partakers are therefore authorized and expected to divulge their portfolios at the end of the business day.

That’s directly opposed to what mutual funds managers are obliged to do as they are only required by law to disclose their holdings on a few occasions throughout the year.

Fragmentation – A Barrier for Growth

Challenges come with the territory and the fragmentation of the industry and specifically this sector, has been a problem for almost a decade.

The pan-European platform for securities settlement, TARGET2-Securities seems to be the light at the end of the tunnel when solving the issue of geographical fragmentation.

Couple that with regulations such as MiFID II – the revised Markets in Financial Instruments Directive – and what you have is an environment that’s shifting in favor of ETF investment.

The regulation is believed to be able to shed some light on the question of exchange trading versus over-the-counter trading.

In this report, Adriano Pace, head of equities, Europe for ETF Trading Platform Tradeweb gives you an idea of what the MiFID II impact is to the market. He describes it as ‘particularly beneficial for the ETF market’ as every single trade has had to be reported since 3rd January 2018.

“MiFID II has increased investor confidence in the depth of the ETF market,” Pace says. “It’s an important point because before you could only see the liquidity on the exchange. It’s helped us because clients are more confident in executing large trades electronically.”

Things are still in the making though. It’s hard to deny that the European market has been prejudiced against OTC trades although trading data is now available.

In a recent interview with ETF Express, James McManus, investment manager and Head of ETFs at digital wealth manager Nutmeg said the following: “The revolution promised by MiFID II has not happened as yet. ETF providers need to ensure investors have access to the right data. Investors can’t easily see the full extent of the picture.”

What Will Drive ETFs Forward?

ETFs are growing and at the same time, they are changing. They are currently used for a buy-and-hold of funds, as tactical asset allocation vehicles and trading instruments.

As we’ve previously described, the notion that precedes ETFs is one of a passive investment. This notion seems to be changing as they are now perceived as active portfolio funds.

According to Morningstar, as of 2017, 39% of asset allocation strategists use ETFs. Asset allocators see ETFs as a pool of granular choices when it comes to accessing stocks, bonds, commodities, and other assets across the globe.

The cost will always be the driving force in business. Any way you choose to look at it, cutting back on costs and maximizing your return potential is the reason behind any investment in any sector or industry.

A recent survey by Morningstar which evaluates trends in the cost of U.S. open-end mutual funds and exchange-traded funds (ETFs) stated the following:

“The study found that across U.S. funds, the asset-weighted expense ratio dropped to 0.48% in 2018, compared to 0.51% in 2017. As a result, investors saved an estimated $5.5 billion in fund fees in 2018. This 6% percent year-over-year decline is the second largest recorded since Morningstar began tracking asset-weighted fees in 2000.”

What’s the moral of this little finding? The fact that the strategy of indexing coupled with the huge advancements in financial technology have opened the floodgates for a transition from active mutual funds into ETFs.

To support this claim comes evidence from a BlackRock Survey stating that “about $930 billion exited actively managed U.S. equity funds from 2009 through 2017, while about $848 billion moved into comparable ETFs.”

Then, there’s the advisory model transformation. Financial advisors used to make their money on a commission-based model.

They would receive a commission to trade securities on the clients’ behalf. Things are now changing and advisors are shifting into a completely different modus operandi.

Since they are now compensated with a fee covering all assets, they are inclined to advise on lower-cost investment products.

Do lower-cost investment products sound a lot like ETFs? We think it does.

Just to give you an idea of how this minor change in the mechanics of financial advisory is causing seismic changes in the entire landscape of ETF investments, BlackRock estimates that about 2/3 of new cash that moved into U.S. ETFs in 2017, came as a result of the phenomenon we just described.

The potential for ETFs in Europe is massive. According to CEPS, a leading think of Europe, “ETF turnover totaled €721 billion in December 2017, up by 63% over 2013.

Despite the impressive performance, European turnover is equivalent to only 5.5% of US market turnover at end-2017 (€13.2 trillion).”

Whilst the willingness is there, there’s a lot that needs to be done for Europe to catch up with the US. Regulation and policy are certainly the foundation if such a change were to occur.

The recently enforced MiFID II requires every ETF transaction to be reported and also holds a provision for the establishment of a consolidated tape for financial instruments.

These are important steps in establishing a level playing field for investors.

A marketplace characterized by transparency where they can see an instrument’s trading volume across multiple exchanges and form a consolidated idea of the market.

For more information, education and advice on ETFs and Forex trading, feel free to navigate through EverFX.

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