Unless you have been living under a rock for the past two years, you will know that exchange-traded funds (ETFs) are currently taking over the asset management industry. According to research from Bank of America, nearly $260 billion of assets have flowed out of long-only equity mutual funds year-to-date while ETFs have attracted $151 billion. It is widely expected that this trend will continue. According to global consultancy EY, growth in exchange traded fund assets will continue at its current pace and assets are on track to reach $6 trillion by 2020, up from $3.4 trillion as of August 2016.
The financial services industry seems to be split on whether ETFs are good or bad for the industry. The products have their drawbacks and advantages, low costs and easy trading are the most prominent advantages while investor crowding and illiquidity are some key disadvantages.
However, for value investors, I believe ETFs are somewhat of a gift thanks to their rigid structure.
A gift to value investors
There are thousands of ETFs out there, all of which attempt to follow different styles and strategies. There are so many of these products that they are now replicating strategies over and over again. The problem is that this crowding is reducing disparity and all styles as well as indexes are becoming highly correlated. With most ETF assets invested in broader indices, active flows inherently contribute to less disparity. Smart beta strategies only add to the confusion. As these are focused on the main themes or factors (value, momentum or growth), inflows can drive greater disparity at the style level. As money flowed only to those names in the momentum index, they would rise while others would not.
For value investors, this opens an opportunity. As passive investors crowd into ETFs, certain areas of the market and stocks are being neglected, which is increasing the opportunity set for those investors who are willing to put in the extra work and search for bargains. At their core, ETFs are rules-based investment vehicles. Due to the low fees charged by these investment vehicles, there is an incentive for managers to operate on scale. Therefore, ETFs are designed to be able to grow a large enough asset base to be profitable. The only way they can do this is to contain stocks of companies that are large and liquid enough to allow them to grow to the required size. Put simply, the industry is structurally biased towards focusing on large capitalization stocks and against smaller illiquid companies.
Herein lies the opportunity for value investors. Those businesses that are left behind by the large ETFs are still attractive businesses, but they will be neglected by the market due to structural factors at the fund management level. It has nothing to do with the underlying business.
As well as the structural issues of the ETF market, which should throw off plenty of opportunities for value investors, ETFs themselves can be a great tool for value investors.
Spread your bets
Benjamin Graham believed that to be a successful value investor, the enterprising investor had to spread his bets across 30 more deeply discounted companies, diversify away risk and produce the best return on his or her capital. There is also a need for diversification at the sector level. This is where ETFs can help the average investor as they offer a broad sector diversification at a minuscule cost. For example, if you wanted to take a contrarian bet on the oil industry at the beginning of 2016, or financial sector in the depths of the financial crisis, you have three options. One, spend days researching some select stocks and hope you have made the right choices. Two, buy a basket of stocks for your portfolio and hope some of the bets pay off and commissions do not eat all your returns. Or three, buy a low-cost diversified ETF to give you exposure to the sector with minimal research required at a relatively low cost. It is evident the ETF offers the best solution for the investor.
So overall, the rise of the ETF is, broadly speaking, good news for value investors. There is no need to fear the industry.
Disclosure: The author does not own any share mentioned within this article.
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