ETF Funds Really Are Better Built Mousetraps

Paul Tyers CA, CFP, CIM
Director of Professional Services
HAHN Investment Stewards

It is true that the worldwide exchange traded funds (ETFs) space is booming. Listings and trading volumes have soared in recent years. Deutsche Börse's pan-European Xetra trading platform now lists 326 ETFS with an average monthly trading volume of over nine billion. In Canada, Horizons Betapro with a range of bull/bear offerings has already accumulated assets of over $1.75 billion, despite being a relatively new ETF provider.

Due to their underlying attributes of lower costs, lower taxes and one-stop diversification, they have definitely been growing; mostly as an alternative to investing through mutual funds. In 2003, global ETF assets made up 1.5 per cent of world mutual fund assets. That number grew to 2.3 per cent in 2005 and 3.05 per cent in 2007.

While ETFs are consistently gaining ground against mutual funds, they still have a long way to go, primarily due to the mutual fund industry's tremendous ability to hold on to a cash cow.

With the rapid proliferation of exchange traded products in the last decade (from only 21 ETFs worldwide in 1997 to 1,171 ETFs globally as of year-end 2007), some have concluded that the ETF marketplace is heading toward its own bubble. But is it really happening, or is this really an effort by the incumbents (the mutual fund industry) utilizing the old motto ‘the best defence is a good offence'?

Let's first examine the ingredients and conditions that are necessary for the development of an asset bubble. Broadly speaking, three main factors work together to produce this: positive economic fundamentals (initially, at least), investor misconception, and financial leverage. The first and second factors produce a widespread belief in a ‘new paradigm.' The third factor is the fuel that drives prices upward, provided that there is ample expansion of money and credit.

Clearly, the impetus for a financial bubble must initially have some fundamental economic merit. As investors experience gains in the related asset, fundamentals are ignored and a broad-based investor misconception eventually takes hold. Ultimately, the concept is taken as truth and extrapolated ad infinitum.

As the bubble phase is entered, traditional constraints of supply and demand are dismissed. This is the greed phase, where investors believe that it is truly different this time. In a capitalist economy, an increase in the price of an asset should produce a normal competitive supply response. But during bubble periods, investors do not anticipate any response at all. In fact, the data is mostly ignored, even while the fundamental trends have reversed course.

Lastly, and perhaps most importantly, bubbles include rapid credit expansion with the targeted asset serving as collateral. In most cases, a positive feedback loop develops that causes asset prices to move beyond intrinsic values. Creditors are emboldened to take on more risk by the further rise in asset prices, while debtors are willing to borrow more and bid up the price of the asset.

Whether the financing is provided from traditional channels such as commercial banks, or funding is accessed through capital markets (equities, bonds, etc.), market manias typically have a central feature of financial liberalization. Most recently, the global real estate bubble expanded along with the largest credit boom in financial history.

How are asset bubbles usually pricked? Whether it is a financial disaster (e.g. hedge fund blow-up) or an inability to service the debt load, the decline may be initiated by any number of catalysts. But pricking a bubble can be compared to playing with matches in a room filled with gasoline fumes - an explosion will happen.

During the inevitable bust phase, a negative feedback mechanism develops which prolongs the decline and subsequently causes prices to fall; often below fair value. Some economists have theorized that the magnitude of the bust is proportional to excesses created in the prior boom. As asset prices serving as collateral on loans collapse, creditors begin calling in their loans and raising the cost of capital. Default rates spike and bankruptcies erupt. Investor misconceptions which promoted the bubble are quickly replaced with fear and the obviousness of prior investor foolishness. With investor revulsion, the life cycle of a bubble is complete.

At this point, opportunities abound for brave-hearted value investors.

Does the bubble theory apply to ETFs? An ETF is actually benign since it's simply a structure holding underlying investments, not a vehicle which influences underlying price of the basket of securities held. Let's evaluate through the prism of the bubble theory.

Is ETF growth based on underlying economic impetus? Sure, the fundamentals are lower cost, better tax efficiency and ease of diversification.

Is ETF growth based on any investor misconception? There is no evidence of this. Since ETF use is being led by more sophisticated market participants such as institutional money managers and high net worth investors, the argument can be made that these early adopters have simply found a more efficient methodology. I would argue that the lower echelon of market participants is under the misconception that mutual funds and their pooled fund cousins are still the only viable way to achieve diversification while investing in various sectors.

Most importantly, there is no evidence that ETFs are widely used as collateral for widespread borrowing by investors. In fact, the opposite could be claimed as the overly extended credit markets de-leverage in response to the credit crisis that used real estate values first and consumer credit capacity second as their collateral of choice.

What is the future of ETFs? Consider today's ETF climate. In the context of declining global equity markets, ETF product launches have slowed and some closures also being announced. Does this then mean that an ETF bubble is deflating? No. In fact, product closures and management expense ratio competition among ETF providers is healthy and is a positive for the industry. Make no mistake, ETF usage and listings will continue to expand for the simple reason that they are a better mousetrap than many traditional ‘pooled' investment vehicles.

But given the reality that investors will face a world of persistent bubbles, how should they manage the future? Some economic pundits will say you can't avoid bubbles. From a policy-making standpoint, some disagree. For example, the U.S. Federal Reserve could have thrown cold water on the dot-com frenzy by raising margin requirements. More recently, policymakers around the world could have imposed restrictions on innovations in exotic security types and home down payment requirements to rein in overzealous mortgage lenders.

Markets are not always rational. Therefore, investors cannot take an exclusively passive approach. Rather, a disciplined value and risk-sensitive approach should be employed which emphasizes material strategic shifts and eliminates emotional biases.

For information and inquires contact:
John F. Brown at 1-800-927-5288f

This report was produced by: HAHN Investment Stewards & Company Inc. Phone: 888-957-0602 and is reprinted with kind permission.