Talk of crash in $3trn ETF industry

Retail investors are finding Exchange Traded Funds (ETFs) an increasingly attractive alternative to open ended investment companies (OEICs). They're simple, cheap to buy, and investors get a liquid stock diversifying exposure to otherwise difficult-to-access markets or specific sectors. However, a pioneer of the ETF strategy is worried by this popularity and, in a controversial move, has warned it could be about to trigger a market crash.

After taking off in the US two decades ago, the global ETF market is now worth $3 trillion (£2 trillion), with around 6,000 products available to investors. Granted, the vehicle is yet to catch on in the UK, but demand has increased sharply in the post-Retail Distribution Review world, as advisors look at vehicles they wouldn't have previously.

With 886 products now listed on the London Stock Exchange, £26.3 billion was traded through ETFs in February alone, up by over a third on the same time last year. The London bourse is now the largest ETF trading platform in Europe, with over 32% of the market.

ETFs share similarities with their OEIC counterparts: both own a bundle of securities offering investors diverse exposure to a slice of the market. Equity-focussed ETFs are an investor favourite, although recent volatility caused an influx of capital into fixed income funds, according to the latest data from investment manager Blackrock.

While investors buying into OEICs pay the fund's net asset value at that day's close, ETFs act more like equities and can be traded on the stockmarket, giving them higher intra-day liquidity. This also gives investors the opportunity to short an ETF if they believe its value is about to fall.

The active v. passive debate

Two investment styles are generally associated with funds: active and passive management. While passive funds track indices, with managers adapting the weighting to mirror a particular index, active managers have more control over their holdings and tempt investors with the possibility of market-beating returns - obviously they can underperform the market too. Unsurprisingly, active managers charge more for their stockpicking skills.

As ETFs aren't actively managed, they have historically charged lower fees than their OEIC pals. However, this low-cost comparison has recently come up for debate. A report by Morningstar warned that so-called "smart beta" ETFs can be a way for providers to recover some of the profit lost due to other fee cuts, with synthetic, derivative-based ETFs usually attracting premium price tag.

Most tracker funds use market capitalisation to rank the weighting of the underlying holding; for example, a fund tracking the FTSE 100 would have highest exposure to oil giant Royal Dutch Shell, the largest stock on the blue-chip index, and lowest exposure to telecoms company Inmarsat, the smallest company on the Footsie.

But market capitalisation isn't necessarily the best indicator of performance, and a lot of value can be lost by adapting your portfolio in reaction to market value changes. After all, the index was designed as a measurement, not an investment vehicle.

So it's a general misconception that all ETFs are index trackers. In fact, most adopt a smart beta strategy to boost their returns by including different technical rules to remove the emotion that often comes with stockpicking.

Managers can choose instead to focus on any other measure of quality, including dividend yield, book value and earnings. Investors can also pick ETFs that screen for low volatility, high quality and high momentum characteristics.

So what's caused all the fuss?

Well, investment guru and smart beta pioneer Rob Arnott recently warned that their exponential rise in popularity has made these ETFs too expensive compared to the rest of the stockmarket.

Creating an illusion of market-beating returns, an influx of capital has sent valuations levels rocketing, which reduces the return profile for that asset and increases the risk that valuations will return to past norms. If investors continue to chase performance, valuations will continue to dwarf fair value, increasing the likelihood of a crash.

"Are we being alarmist? We don't believe so. If anything, we think it's reasonably likely a smart beta crash will be a consequence of the soaring popularity of factor-tilt strategies," Arnott recently warned in a paper for Research Affiliates, the company he founded and still runs.

This caution against performance chasing has sparked controversy, with Arnott later qualifying to the Financial Times: "We're not saying [smart beta] can't add value; we are saying look before you leap."

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.