Exchange Traded Funds (ETFs) are wonderful, easy-to-use and efficient financial instruments. Yet, although these ETFs are relatively simple investment vehicles they do allow for the implementation of rather complex investment strategies. ETFs add substantial value at reduced cost to uncounted numbers of portfolios. ETFs are a game changer even in an industry such as asset management which has never been characterized by a short supply or a scarcity in innovation and fresh ideas.
Financial instruments transforming the asset management industry
Indexing & More has become highly fashionable with investors and many of them seem to think ETFs have become a must-have. Exchange Traded Funds have thus created — and embraced — a mass-market. The fact that they increasingly cater to a vast array of investors ranging from hedge funds, sovereign wealth funds, pension funds and even retail investors, these financial instruments have been transforming the asset management industry more than any other innovation in the last ten years.
The growth of the volume invested in ETFs remains explosive.
According to a recent study from PWC, entitled “ETF 2020 — preparing for a new horizon”, ETFs store USD 2.6 trillion of assets around the globe. Based on its own survey, PWC writes that assets under Management in ETFs are expected to more than double and even exceed USD 5 Trillion in 2020. In the study, PWC expects ETFs to receive an additional boost especially in the coming years as they find a growing acceptance among more types of investors. The big auditing firm explicitly mentions Asia as a marketplace where the growth of this category of instruments can be expected to be extraordinary strong.
But, as to every good thing in life, there is a downside to all this perfection, and maybe even a few. The first downside is that we are witnessing a declining degree of overview or transparency for the investors, which is a natural side effect of explosive growth and great success as well as a natural consequence of the meteoric volume growth and substantial increase in the origins of this type of financial instruments.
Deutsche Börse’s Xetra is the biggest trading place for ETFs in Europe. It services the listings for 1051 ETFs with an average monthly trading volume of EUR 11 billion. Apart from this, a rapidly expanding variety of ETFs’ indexing methods and stylish product designs, such as “smart Indexing” and other more sophisticated ETF-architectures, incessantly put new streets, alleyways, paths and buildings on the map of finance’s fastest growing city, boomtown “ETF-City”, making it difficult for investors to find their way in this flood of offerings while creating rich opportunities for fledgling advisory firms specializing on ETFs at the same time.
Another possible downside may be that ETFs that replicate a certain asset or category of assets without holding them physically run counterparty and liquidity risks that may not always be transparently disclosed to the investors in the scheme. Such risks would only become obvious in situations of severe market disruption for the assets in question
At that time, it will most likely be too late to avoid heavy losses.
This is what Corporate Governance can contribute to a critical evaluation with regards to ETFs: Passive investing as it is often called can decrease the level of responsible ownership of equity invested in listed companies; pressure resp. corporate control is felt by the management of a corporation to a lesser extent or is somehow diluted. In case things have become rather “passive” and when less or no more curious and intrusive eyes are watching the actions of those who need to be supervised by investors, fraud and corporate wrongdoing may lurk around the corner.
Damage recovery
Finally, when it comes to damage recovery, investors should consider the implications of a substantial share price decline of a stock or another financial instrument which is held by an ETF following a fraud, misrepresentation or a delay in the legally required disclosure of information to investors. The possibility of a loss or of losses in the portfolio of ETFs and its consequences in contrast to an active investment management under certain circumstances can represent an issue that investors in ETFs should take into account. Moreover, in the course of a recovery action, in certain jurisdictions an investor may be required to demonstrate that he has relied on certain information when making the purchase decision.
For an ETF it might be more challenging to overcome the burden of proof of reliance than for other investors. As mentioned above, ETFs are fantastic and efficient financial instruments. Therefore some factors (or a missing leg) need to be considered before investors join these powerful spiders with so many legs in their march towards the next trillion USD of assets added.
