Confusing Means and Ends

This morning’s Wall Street Journal informs us that the growth of exchange-traded funds has “propelled” this year’s surge in equity prices.  “Booming demand for passive investments is making exchange-traded funds an increasingly crucial driver of share prices….Surging demand for ETFs this year has to an unprecedented extent helped fuel the latest leg higher for the eight-year stock-market rally.”

Or has it?  Suppose I edit the sentence quoted immediately above to read “Surging demand for equities this year has to an unprecedented extent helped fuel the latest leg higher for the eight-year stock-market rally.”  I’ve changed only one word, and yet the entire connotation of the sentence is different.  “Surging demand for equities” means only that investors, as a group, want to increase their exposure to the stock market.  In hindsight their decision may or may not prove wise, but it’s hard to make such a choice sound sinister.

ETFs are not a unique asset class.  They are a means by which investors can invest in the assets which have long formed the core of their portfolios.  There are, of course, a number of advantages to the ETF structure – transparency, ease of implementation, access to institutional strategies for the small investor, low cost, tax benefits – and these advantages may go a long way to explaining why an investor might prefer ETFs to traditional mutual funds.  But an ETF, mutual fund, or separate account are simply different ways to hold a given portfolio of assets; as such they are less important to an investor’s ultimate success than the choice of which portfolio to hold.

And for that choice, investors have increasingly realized that their interests are best served by placing passive index vehicles at the core of their portfolios.  Active managers, as a group, have consistently underperformed passive benchmarks, and above-average active performance, when it occurs, tends not to persist.  As the Journal recognizes, these facts have resulted in a continuing migration of assets from active managers to index-linked portfolios.  ETFs are not the cause of this shift, but rather one of the vehicles by which it is taking place.

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