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(Shapiso/© Lee Phek Thong, all rights reserved)
(Shapiso/© Lee Phek Thong, all rights reserved)

ETF revolution: The lighter side Add to ...

I marked the 20th anniversary of the SPDR S&P 500 exchange-traded fund by pointing out that the popularity of ETFs has come with an unintended downside: Since they are so easy to trade, investors do just that. All the buying and selling has driven up overall costs and driven down portfolio performance as investors miss out on rallies.

The Vanguard Group, which offers a number of its own exchange-traded funds, has a different view – shared with me through a research note published in July: While ETF trading activity suggests investors are flipping funds in an effort to time the market and juice returns, you have to make a distinction between institutional and retail investors. The pros are doing the flipping, while small investors remain buy-and-hold types.

“The presumption that ETFs encourage people to trade is typically based on macro-level trading data,” said authors John Ameriks, Joel Dickson, Stephen Weber and David Kwon, pointing to the extraordinary turnover rate for the S&P 500 ETF in particular.

“However, such high-level data are often dominated by the trading and hedging activity of large institutional investors and consider transaction activity at the fund level as opposed to the investor level. Consequently, the data do not reveal much about the behaviour of individual investors and their financial advisers.”

The authors were given access to the transaction and account records of Vanguard clients, which allowed them to make relative comparisons between mutual fund trading and ETF trading between 2007 and 2011. They found that the majority of investments were buy-and-hold – 83 per cent of mutual funds and 62 per cent of ETFs – which they defined as held for more than one year. Just 12 per cent of ETFs were entirely bought and sold within a year.

The average holding period for a mutual fund was 42 months, compared to 34 months for an exchange traded fund. In other words, mutual funds were held longer and traded less often, but ETFs were hardly day-traded.

“Although behaviour in ETFs is more active than behaviour in traditional mutual funds, some of that difference is simply due to the fact that investors who are inclined to trade choose ETFs, not that investors who choose ETFs are induced to trade,” the authors said.

“We conclude that the ETF ‘temptation effect’” – that is, the temptation to time the market using easy-to-trade ETFs – “is not a significant reason for long-term individual investors to avoid using appropriate ETF investments as part of a diversified investment portfolio.”

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