Separating fact and fiction in ETF investing

04-28-2021
Separating fact and fiction in ETF investing

Dispelling four persistent myths about ETFs

 

Like grey clouds that don’t lift, some ETF myths keep hanging around, obscuring the value of a proven investor option. Let’s let the sunshine in. Here are four myths/fictions that should be sent on their way.

1. ETFs “cause” market crashes

This is likely the top ETF myth. It lingers without valid evidence, thriving on a misinterpretation that reverses cause and effect.

Similar to stocks, ETFs are market-dependent. When global or national events or other factors cause investor sentiment to change, markets fluctuate. When markets move, ETFs follow – not vice-versa. When market volatility increases, ETF trading also typically rises. Nevertheless, some observers contend that ETFs cause this volatility and distort portfolio securities. But actually, when ETF prices fluctuate, it’s an effect of underlying market volatility, not a cause.

Market crashes happened before and after ETFs launched in 1990. Human behaviour has been behind every market crash from the Great Depression to the tech bubble to the global financial crisis to the “Coronavirus Correction” of 2020. These upheavals were not caused by one factor or security type – ETFs postdate the Great Depression by decades.

ETF uptake is growing rapidly globally (for good reason). But the ETF market is still small relative to the overall securities market. In Canada, ETFs represent 15% of investment fund assets and they’re about 6% of global equity markets. ETF trading is a fraction of the total in any imaginable scenario, so it’s the broader market that’s driving prices.

Associating ETFs with market instability simply isn’t credible.

2. ETFs are “riskier” than mutual funds

Here’s another flimsy myth. It claims that the risk profile of ETFs is higher than traditional mutual funds. But ETFs and mutual funds are basically identical, so how can one be riskier than the other?

Both mutual funds and ETFs are baskets of securities. They are sold in shares/units, and offer diversification via an accessible investment vehicle. Those baskets may contain stocks or fixed-income securities (or both) from any region or sector. They only differ in how they’re structured, bought, sold, and taxed.

A variety of risks are equally associated with mutual funds and ETFs holding market-based securities, including currency risk, inflation risk, country risk, etc., and both types of funds are exposed to standard market risks. But research does not confirm that ETFs are riskier than their mutual fund counterparts based on their structure.

If you were dining out and wanted to know how spicy a menu item was, you wouldn’t ask what it’s served in but about its ingredients. This also applies when considering ETF and mutual fund risk profiles: Focus on the underlying holdings, not what holds them.

There’s no convincing data that prove ETFs are riskier than mutual funds. Risk emerges from the underlying securities – not their packaging.

3. ETFs can’t beat the market: stay with mutual funds/alternatives

This tends to arise when S&P Dow Jones Indexes releases its SPIVA Scorecard. SPIVA illustrates the performance of active investment funds versus their comparative indexes, but it’s usually interpreted as mutual funds versus ETFs.

For the five-year period ending Dec. 31, 2020, 98.63% of all funds in Canada underperformed the S&P/TSX Composite Index. For the same end date, over three years, 91.07%, and over one year, 87.50% of funds did not exceed this index.

Passive investment critics (most ETF assets are in this category) argue that they can’t deliver better-than-average returns because the modest management fee deducted from them means they’ll always lag their respective index. However, the SPIVA report should also prompt investors in actively managed funds to question what their investments offer. Are higher fees associated with such funds justified if they consistently underperform their benchmarks? Investors should ask if it’s worth paying more for active management given that higher fees do not consistently translate into higher returns.

An investor may be willing to accept a higher fee to have securities selected according to a preferred style or conceivably to seek downside protection that an actively-managed fund offers. But the assertion that ETF investments don’t provide value because they track an index does not hold up to scrutiny. When all factors are considered – including ETFs’ typically lower cost and tax advantages – it’s clear that ETFs can reward investors effectively and efficiently.

4. ETF are inherently prone to liquidity risk

ETF skeptics have alleged that ETFs with low trading volume are risky because they cannot be easily traded, i.e., they suffer from illiquidity (minimal transactions), so trades could affect an ETF’s price.

However, unlike publicly listed shares, ETFs do not have a fixed number of units outstanding. Like mutual funds, they’re open-ended, which supports liquidity. Additionally, ETFs differ from individual shares in that there are two levels of liquidity: primary and secondary. An ETF’s trading volume on an exchange – the visible part – is only its primary liquidity.

Secondary liquidity pertains to the underlying basket of securities an ETF portfolio represents. This is a core ETF feature: that the supply of shares is flexible – they can be “created” or “redeemed” to offset changes in demand. Liquidity in one market – primary or secondary – does not therefore indicate liquidity in the other market.

In fact, there are many factors that affect an ETF’s liquidity, including securities’ bid/ask spreads, how easy is it to trade underlying securities without affecting their price, and an ETF’s ability to respond to investors’ trading behaviour. Additionally, while two Canadian exchanges list and actively trade ETFs, there are actually 12 other markets where they may be bought/sold. Only one exchange’s trading volume might be visible; therefore, the true trading volume could be underrepresented.

So CETFA’s closing message is that illiquidity concerns are not warranted based on how ETFs work and their innate liquidity strengths. Those misplaced concerns should not deter investors from prudently investing in ETFs.

Be ETF smart: don’t buy into myths or fictions

This article responds to familiar falsehoods about ETFs, but you may encounter others, including skewed comparisons with competitive products. It’s time to reject them. Use CETFA resources to send them packing.

Pat Dunwoody is the Executive Director of the Canadian ETF Association. She can be contacted at patdunwoody@cetfa.ca.

Notes and Disclaimer

© 2021 by Canadian ETF Association. All rights reserved. Reproduction in whole or in part by any means without prior written permission is prohibited. Used with permission.

Trading commissions, management fees, and expenses all may be associated with ETF investments. Please read the simplified prospectus before investing. ETFs are not guaranteed and are not covered by the Canada Deposit Insurance Corporation or by any other government deposit insurer. There can be no assurances that an ETF will be able to maintain its net asset value per security at a constant amount or that the full amount of your investment in the fund will be returned to you. Fund values change frequently and past performance may not be repeated. The foregoing is for general information purposes only and is the opinion of the writer. No guarantee of performance is made or implied. This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice.