How passive are exchange traded funds?

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With over 6 000 exchange traded funds (ETF) listed on global stock exchanges and more than 100 such products listed on the Johannesburg Stock Exchange (JSE), index tracking products have firmly established themselves as popular investment vehicles. But how are ETFs structured to be classified as passive investment products? 

The listing requirements of stock exchanges require that ETFs should track an index or a defined asset class. They do this by physically holding 100% of the shares or securities in the index in the correct weighting and numbers required by the constructors of the index. To ensure the 100% physical cover, most stock markets require physical delivery or redemption of ETFs on demand. So an investor can deliver their ETFs to the issuer and demand the physical shares that make up the index basket in return. This ensures the issuing company owns an exact basket of the index component securities at all times, to not leave themselves at the mercy of arbitrage and other quantitative traders who will take advantage of any price deviations in the ETF from the index it tracks. 

These features make ETFs pure index trackers, unlike many other index tracking funds, managed under the guise of unit trusts, mutual funds or segregated portfolios. These non-listed tracker products are typically cash settled and do not require physical swaps on demand, so they can use quantitative techniques to provide reasonable tracking solutions. You can track the JSE Top 40 index, for instance, by not holding all 40 shares in the index, which can reduce costs and complications, but at the expense of greater tracking error. The ETF will, however, typically deliver the total return of the index because it exactly replicates the index.

The pure index tracker investment returns delivered by ETFs makes them attractive to not only long-term retail investors and institutional portfolio managers, but also day traders, pairs traders, hedge funds and algorithm systems. Holding a short-term trading position in the index, rather than a single stock, reduces risk. Accordingly, the daily volumes of ETFs, traded on stock markets, can often exceed the trades in individual stocks. 

As a result, some commentators are querying whether ETFs are that passive if they are so involved in active trading strategies. The answer is all ETF products are purely passive in their structure and their use by so many market participants is because of the efficiencies of ETFs in giving pure beta index returns at low cost, with high transparency and liquidity. 

However, this does not detract from the attraction of holding ETFs in long-term portfolios as they give direct access to various asset classes and market sectors. More and more investors, including retail, institutions and retirement funds, use ETFs for long-term investments and the day-to-day high trading activity in ETFs does not detract from their ability to deliver market-beating returns over time. In fact, the high short-term activity in ETFs helps create liquidity and enhances price discovery, which are important in their own right.

By Mike Brown, Managing director, etfSA.co.za