Those who bet Wall Street choose ETFs

Despite the tariff wars with foreign countries and the non-idyllic relations that are looming in Washington between the executive and the Congress, the US economy appears to be increasingly strong, with low unemployment, moderate inflation and rising profits. According to the latest estimates of the FOMC (Federal Open Market Committee) the Gross Domestic Product of the United States will jump 2.2% in 2019 (down from 3% in 2018) and 2% in 2020. This growth context would make the expansion cycle started in 2009 the longest ever. On the investment side, Wall Street did not pray to participate in the party, with the Morningstar US Market TR Index leaping 48% in the last three years and 30% since the beginning of the year (data in euros as of 12 November 2019).

Evolution of the Morningstar US Market TR index since the beginning of the year

Data in euros as of 12 November 2019. Source: Morningstar Direct.

On Wall Street the active manager is no longer in fashion
As far as flows are concerned, the overwhelming preference that US equity investors have towards passive management continues. The table below shows that in all US equity categories, in the first nine months of 2019, passive instruments (ETFs and traditional index funds) did better in terms of deposits than active competitors. Impressive in this sense are the almost 14 billion euros raised in the period by US large-cap blended equity replicants, against the 7.8 billion lost by active funds in the same category.

Historically, in fact, the large indices dedicated to the US stock market (in particular the MSCI USA and the S&P 500) have proved to be decidedly complicated to beat for active fund managers. Many attribute these difficulties to the very high level of efficiency of the US stock market. The term "efficiency" in this case indicates the speed and accuracy with which market participants incorporate new information (economic news, accounting data, etc.) into stock prices. Moreover, given the technological advances and the growth of the portion of assets managed by qualified investors, the market has become increasingly efficient and liquid over time. However, this aspect alone cannot explain the long-term success of index funds, at least those that are broadly diversified and weighted by market capitalization.

Indeed, another advantage of the replicants is the costs. For investment houses, passive funds are intrinsically less expensive than active ones: the providers of index funds they do not have to pay a team of highly qualified managers and analysts, in addition to having a decidedly lower portfolio turnover, which avoids a whole series of accessory costs (various commissions, spreads) bid-ask).

That said, the indices weighted according to market capitalization (such as the MSCI USA or the S&P 500) have some noteworthy drawbacks. By owning "the market", investors rely on other participants to value equities. Considering long periods of time, these participants have all done a good job of evaluation, but these long horizons have also been marked by panic episodes. Traditional benchmarks are in fact subject to bubbles, as they naturally overweight shares that have increased in value and underweight those that have lost ground. For example, during the stock boom dotcom in the late 1990s, the MSCI USA index was largely exposed to technology, media and telecommunications stocks, which eventually collapsed. When the bubble burst, the benchmark dropped by over 40% and it took four years to return to the pre-crash value.

The ETF charge
With 95 Exchange traded funds registered for sale in Italy, Italian investors interested in passive exposure to US equity are spoiled for choice (the three categories of US Large-Cap Equity funds – Blend, Growth have been taken into consideration). and Value – and the Mid Cap and Small Cap categories). Below the top ten in terms of assets and the ten that have raised the most since the beginning of the year.

With almost 32 billion euros under management, the iShares Core S&P 500 UCITS ETF is by far the largest replicant dedicated to the US stock market, among those domiciled in Europe. The fund uses the physical method to replicate the performance of the index. This means that it contains all the titles of the benchmark. iShares can carry out securities lending activities to generate additional revenues. These revenues can partially offset the Ter (Total expense ratio), which is divided between 62.5 / 37.5 between the fund and BlackRock, for which BlackRock covers the costs. Between January 2018 and January 2019, the fund recorded an average of 4.39% of loaned securities, which allowed an increase in the net yield of a base point. To protect the fund from the counterparty risk that arises from this practice (which theoretically can lead to a loss of 100% of the capital), iShares uses a collateral higher than the value of the loan. The levels of guarantee vary from 102.5% to 112% of the value of the securities on loan, depending on the assets provided by the debtor as a guarantee. Current expenses of seven basis points are among the lowest in the category.

Read all the articles of the Special Week dedicated to Wall Street.