'ETFs breed complacency among investors'

After reports suggest shift back to active management, CIO claims index funds are a threat to portfolios

'ETFs breed complacency among investors'

ETFs are a threat to investors and the efficiency of the market, according to a chief investment officer.

Last Wednesday, for the first time in five years, Morningstar unveiled research that showed how active US equity funds had outshone their passive counterparts. The formers’ funds were balanced for the month of January, while passive funds had $3.8 billion in outflows.

Morningstar estimates net flow for mutual funds by computing the change in assets not explained by the performance of the fund, and net flow for US ETFs by shares outstanding and reported net assets.

Gerry Frigon, president and CIO at Taylor Frigon Capital Management LLC, believes that, at their core, ETFs and passive vehicles are bad for investors and that this explains why there is a shift back to active investing.

He said: “ETFs replace an investor’s ownership of securities issued by a business with a synthetic vehicle linked to securities by a process of financial engineering.

“This distancing of the investor from the portfolio of securities that the ETF is supposed to be tracking lowers the perceived need to scrutinize the securities in the underlying portfolio: in other words, it breeds complacency on the part of the typical investor in the ETF.”

Frigon said that even the most unsophisticated investor knows careful analysis is required on a stock but that when an ETF is presented as an option, this detailed analysis of the underlying securities becomes less necessary – or even totally irrelevant.

He added: “There have been attempts to create ‘active ETFs’ which track a portfolio of securities selected by a manager rather than an index or market segment – but even after several years these have less than 1% of all ETF assets, and the majority of them own securities other than stocks.

“We suspect that many active managers would prefer to manage portfolios in which the trading is not driven primarily by arbitrage activities. Arbitrage by its very nature requires liquidity - in more ways than one – and a temporary liquidity shortage could lead to the price of the ETF decoupling from the portfolio of securities it is supposed to be tracking.”