Investors considering different exchange traded fund options will usually have a better outcome selecting a bigger ETF over a small one, according to new research.
Morningstar has analysed the trading history of listed funds and found that big ETFs have consistently lower buy-sell spreads. The big ETFs also tend to have lower management fees.
It found that economies of scale can help reduce costs and increase liquidity. For passive funds, which dominate the ETF sector, capacity constraints are not an issue of concern.
“We’ve long believed that, all else being equal, larger exchange-traded funds are better,” Morningstar says.
There is currently a race to the bottom when it comes to fees. The most recent example is the iShares Core S&P/ASX 200 ETF cutting its management fee from 15 basis points to 9 bps.
“Smaller funds would find it hard to match that,” Morningstar says.
As the ETF market has grown over the past decade, the average bid-ask spread has fallen from 75 basis points to 29 bps.
For big funds it is much lower. The average bid-ask spread for Vanguard Australian Shares ETF, a $3.8 billion fund, is 8 bps and the spread for iShares Core S&P/ASX 200 ETF is around the same.
Morningstar found that smaller ETFs don’t get those benefits, especially if they are in niche asset classes. It tracked four small commodity ETFs and found they had an average bid-ask spread of 61 bps under normal trading conditions.
Morningstar says another reason to think carefully about investing in small ETFs is that they might turn out to be “terminator” funds – ETFs that get shut down because of their lack of scale.
This has happened in Australia on a few occasions but it is more widespread in overseas markets.
There are 13 ETFs listed on the ASX with net assets of more than $1 billion, and another 13 with net assets between $500 million and $1 billion. On the other hand there are 78 with assets of less than $50 million.
The release of Morningstar’s report last week coincided with an announcement from the Australian Securities and Investment Commission that it has notified the ASX and other exchange operators that it does not want them to admit certain types of funds, while it reviews the ETF sector.
The types of funds it does not want listed are actively managed funds that do not disclose their portfolio holdings daily and have internal market makers.
Over the past year ASIC has expressed concern about a shortage of market makers locally, a situation that will be made worse as Deutsche Bank winds down its involvement. It is also concerned about transparency, liquidity, volatile trading spreads and what it sees as a lack of retail investor understanding of the product.
ASIC says its review will run for the rest of the year. It wants new listings of such funds on hold until then, including funds whose admission applications are currently being considered.
It is understood that at least two managers had funds in the pipeline for ASX listing, which will now not go ahead.
ASIC says internal market making occurs when a managed fund’s responsible entity acts as the market maker for its own fund on the fund’s behalf, either by submitting bids and offers itself or by engaging a transaction agent that executes its instructions.
Such funds are usually actively managed funds. ASIC estimates that internal market making funds represent about 6 per cent of exchange traded products by funds under management.
ASIC says it intends to review the regulatory settings for exchange traded managed funds that use internal market makers.
Existing actively managed exchange traded funds are not affected.
In a review of the local ETF market last year, the ASIC said the market was “generally functioning well” and was delivering on promises to investors.
However, it detected some potential risks that require monitoring by issuers and oversight by market operators. It wants issuers to do more to inform investors about the tracking error of funds, indicative net asset values and trading spreads.
And it is concerned that there too few market markers providing liquidity in the local ETF market.
ASIC says: “ETF trading is generally liquid, bid-offer spreads are narrow and secondary market prices are generally close to the NAV is ETF units. However, this does not necessarily apply to all products at all times.”
“In particular, we observed that spreads do temporarily widen in some circumstances, meaning individual transactions may involve a higher spread than an investor may consider desirable. The spread may significantly affect investor return.”
The International Organisation of Securities Commissions is currently doing a study of the ETF product.
Robert Taylor, chair of the committee on investment management at IOSCO, says the study is focusing on how much investors understand about the way ETFs work, the role of authorised participants and market makers, the relationship between the product issuer and the investor, and the increasing complexity of the product.
Speaking at a Financial Services Council conference earlier this year, Taylor said: “Things start with simple variations. Then they get more and more complex. We saw this with structured products pre-GFC. Banks ended up having to pay back a lot of capital because customers did not fully understand wat they were getting into.
“Regulators are interested in making sure we do better than we did with structured products.”
He says that since the GFC regulators have taken a more forward-looking approach to their work, spending a lot of time looking at what the risks could be. One question he asks himself is how ETFs would have performed in 2008.
“People in the industry often don’t see the risks emerging,” he says.
“There is a belief in the liquidity of the product and a belief that this product is better and more efficient. But when you talk to retail investors, it is not clear what they think they are buying. They don’t understand the basic arbitrage functions that supports it.”