At PWL Capital, we believe in passive investing. Instead of actively trying to beat the market, we build portfolios mainly using exchange-traded funds (ETFs) that passively track market indexes.
By now, you probably know that most actively managed mutual funds don’t beat the index. Despite those subpar returns, Canadian investors pay some of the highest mutual fund fees in the world.
By contrast, ETFs are very inexpensive
The average ETF management expense ratio is just .35% in Canada, compared to 1.8% for mutual funds. ETFs hold thousands of stocks and bonds that make up market indexes, allowing you to broadly diversify your portfolio and capture market returns with less volatility.
In addition, research shows a tilt toward small-cap and value stocks can increase expected returns over the long term. ETFs allow investors to efficiently gain exposure to baskets of these stocks.
With all those attractive features, it’s not surprising so many investors are flocking to ETFs around the world. Earlier this year, global ETF assets surpassed the US$5 trillion mark while in Canada ETF assets now total about $160 billion.
So, what’s not to like about ETFs?
Nothing—and there-in lies a potential problem, according to some market observers. They argue ETFs have become so popular that trading in them is making the market a more treacherous place for all investors.
The argument is that when an ETF is sold, every stock in an index is sold, regardless of the fundamentals of the underlying securities. Heavy selling of ETFs during a correction accentuates the downturn by throwing out good stocks with the bad, or so the argument goes. Some observers also contend ETFs allow investors to flee the market more quickly than if they had to sell individual positions.
According to these people, that’s just what happened during a sharp market correction last February that was accompanied by a large outflow of money from ETFs, especially the huge SPDR S&P 500 ETF Trust.
So, is the growth of ETFs making the stock market more prone to a bad correction? I’m not buying it, and neither should you.
First, ETFs currently represent just 3% of the US$160 trillion invested in the world’s public markets. In Canada, ETFs represent a significant but still small 10% of assets held in investment funds (mutual funds, ETFs and segregated funds).
Second, as PWL Research Director Raymond Kerzérho notes, when ETFs are bought and sold the impact is spread across thousands of securities whereas active investors are more likely to have concentrated positions in individual stocks. Selling those positions has a greater impact on share price and can cause more panic selling.
Finally, the two greatest crashes in modern history—the 1929 crash and 1987 Black Monday—occurred when ETFs didn’t exist. In between those two events, there were many other substantial market downturns that had nothing to do with ETFs.
The bottom line is that stock prices in aggregate are driven by economic events such as interest rate movements, growth prospects and financial crises. ETFs follow the action, they don’t lead it.
Of course, this doesn’t mean using ETFs will protect you from a market downturn. Corrections are a part of investing. However, a broadly diversified portfolio, built with an appropriate mix of assets, has proven to be the wisest approach to building your wealth over the long term.
ETFs are a great tool to build that kind of a portfolio. They’re a product that does a better job than the alternatives at a lower price—and that’s hard to beat.