Are ETFs to Blame for Stock Market Volatility?

Vanguard's Mark Fitzgerald tells Emma Wall why ETFs are the best tool for long-term investors in the current market volatility

Emma Wall 11 May, 2016 | 9:42AM
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Last week, Morningstar ran our annual investment conference, on subjects ranging from Brexit and risk management to the cost of funds and the future of advice. Read on for our coverage of the Morningstar Investment Conference UK in our special report: What the Experts Say.



Emma Wall: Hello and welcome to Morningstar. I'm Emma Wall, and joining me today to talk about ETFs suitability for these volatile markets is Mark Fitzgerald, Head of Product, Europe for Vanguard.

Hi Mark.

Mark Fitzgerald: Hi.

Wall: So we've just heard from you at the Morningstar Investment Conference about ETFs and about the volatility they were experiencing in markets at the moment. And there is a school of thought which suggests that ETFs are actually contributing to this volatility. What do you say to that?

Fitzgerald: Well, it's important to remember that the vast majority of ETFs are actually index vehicles, 99% are index vehicles. 91% in the European space are UCITS regulated, that means they follow the same diversification rules and regulations as other mutual and pooled funds.

And ultimately, what most of those products are designed to do is give you exposure to the broad market. You know the benefit of an ETF is you trade once and you gain this exposure to hundreds or maybe thousands of securities. And Vanguard, what we would say is, we value long-term investing. We see the benefit in sort of setting your objectives and being disciplined, and to a certain degree the day-to-day noise of volatility is not to be concerned, you shouldn't concern yourself with it, because you should be thinking long-term, buy and hold.

Wall: I suppose they also add liquidity, don't they? Rather than a lot of volatility is caused by inaccessible markets, people investing sentimentally because they are scared that they not be able to access certain assets. Whereas ETFs, because of the nature, because they are traded like a stock on an exchange actually add liquidity to markets which probably need it.

Fitzgerald: That's a very good point. So fundamentally, an ETF is a wrapper. It trades like a stock, it's a fund and it's a function of the marketplace. It's a reflection of the marketplace, that's why you buy it. So, it doesn't create volatility. It reflects the market.

Now what it does do and what they do, do very successfully is they add a layer of liquidity and by that what we mean is that if you look at the most traded ETF, both in Europe and the U.S., 99% of the trading is secondary market trading, so that's investor to investor. The fund assets are not touched and that's quite different from mutual funds. So that's another layer of liquidity and that can help in volatile market and it can help in times where there are liquidity concerns, because of that the structure of them is to benefit.

Wall: So, we've declared the product not guilty, but what about the investors because there is evidence to suggest that actually ETF investors hold investments for shorter period of times than perhaps active management mutual funds and because of the speculation, because of the nature of which they are investing, actually their risk to crystalize losses because that dipping in and after the market, they are increasing trading cost themselves and as we all know market timing is incredibly hard to do. So how do we manage that element?

Fitzgerald: Again, it's a good point and Vanguard doesn't – because of its buy and hold nature and the advice we don't advocate market timing incredibly difficult, it's almost impossible to do. The nature of ETF is that if you look in the U.S. which is much more mature, much more developed marketplace, the split between retail and institution was about 50-50. They have their equivalent of RDR before us. Now what we found is the concentration on cost is we would expect there to be over time greater emphasis on index funds and ultimately ETFs in the retail market.

At the moment though in Europe, you could say may be 85% of AUM in ETFs is held by institutions and so they do have different trading patterns. Now many of them all buy and hold, they are big institutions sovereign wealth funds that type of thing and they have a buy and hold nature. But there are some of the market participants who will use them for more tactical purposes, and that's part of the flexibility that an ETF offers. But you don't have to use it like that and we wouldn't advocate using it like that.

Wall: And I believe your founder Jack Bogle has said often that people need to vote with their feet and indeed that they have done in America because fees are the only reliable predictor of future returns and so unless active management comes way down people are going to just move across to ETFs.

Fitzgerald: Yeah, and that's the thing there. So, one of our key messages, the discipline, the long-term nature, buy and hold and control what you can control, i.e. costs. And the more participants you have the more product, it gets competition, you've seen price compression, seen it in the U.S., you've seen it in the European space, in the U.K. space in mutual funds and ETFs and we would expect to see that continue. And that's to the benefit of investors because of the nature of the impact the costs have, every little you save compounds over a long period of time.

Wall: Mark, thank you very much.

Fitzgerald: Thank you.

Wall: This is Emma Wall for Morningstar. Thank you for watching.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Emma Wall  is former Senior International Editor for Morningstar