In the present low-interest rate scenario, most retail investors follow a strategy to preserve capital while earning a reasonable yield for the risk taken. This strategy can have various versions depending on the risk that every individual investor is prepared to take.
The investment services industry has developed various structures to help investors with different risk appetites achieve their aim. One element that is fast changing the attractiveness of some investment structures is investors’ consciousness of the effect of fund management expenses on their yields.
Exchange-traded funds (ETFs) are arguably one of the most efficient investment vehicles for retail and institutional investors. A basic definition of an ETF is “an investment plan that can be traded like shares on many stock exchanges worldwide. Generally, an ETF works to replicate a standard element within the stock exchange, such as the Standard & Poor 500 index”.
The first ETF was launched in the US in 1993 but did not become popular with retail investors until the early 2000s. Today, ETFs are a popular mainstream vehicle for both retail and, to a lesser extent, institutional investors. ETFs come in various flavours, including fixed income investment-grade bonds, sovereign bonds, equities and commodities.
The debate on whether active investment strategies by fund managers offer superior returns to passive investment mutual funds and ETFs rages on. I have yet to meet a fund management executive that acknowledges the often recurring research finding that few active managers outperform established indices. After all, index-tracking, especially through investment in ETFs, dents the sustainability prospects of the active fund management industry.
There are, of course, some cases where active management is advisable. These include investments in complex products like commodities and challenging markets like those in emerging economies. In these circumstances, the cost of market research added to the total expenses incurred by a fund manager might be justified for both retail and institutional investors.
ETFs, like all other investments, are not risk-free. The only guarantee one gets from investing in a particular ETF that fits his risk tolerance profile is that the total expense ratio for ETFs is likely to be lower than that of both passive and active mutual fund managers.
ETFs are not a silver bullet that will resolve the dilemma many investors face trying to get the best risk/return balance for their money
The most significant risk an ETF investor must be aware of is market risk. An ETF is only an investment vehicle, a wrapper for the underlying investments like a mutual fund. Fixed income investments come with different risk grading.
A recurring concern is that many investors still do not understand how risk is priced. They base their decisions on the coupon linked to a particular bond or on the advice given by brokers who may not always be guided by what is suitable for their clients.
Unfortunately, COVID has forced regulators and some governments to dilute the robustness of regulations meant to protect investors from the consequences of being misguided in investing in going concern companies.
The ECB and the European Commission are slowly beginning to tighten up again on regulations meant to ensure that only viable businesses are allowed to survive. This may seem controversial and cruel, but it is one of the best ways of discouraging moral hazard.
If professional investment advisers and brokers are to gain the community’s respect, they must hold themselves accountable for the advice they give to their clients. Most professions envy the respect that the medical profession generally enjoys in the community. This respect comes from the observance of high ethical and medical standards to ensure the best outcome for every patient seeking a doctor’s advice.
ETFs are not a silver bullet that will resolve the dilemma many investors face trying to get the best risk/return balance for their money. Lowering the expense ratio by cutting layers of human intervention in the investment process is further proof that the digitalisation of services also affects the investment industry.
In the US, investment in ETFs has surpassed that in passive mutual funds. The trend is likely to continue even when interest rates return to normal as investors become increasingly aware of the impact the total expense ratio has on investments in mutual funds.
Financial education is one of the best ways to help people understand how to make sure that their hard-earned money gives them the best return. This education should start in secondary schools and be extended to tertiary education institutions.
It is indeed worrying that even some very experienced professionals in all fields of knowledge lack the basic skills of assessing financial risk.