ETFs have become a vital part of the investor toolkit, but many misconceptions about the products remain.

Myth 1: ETFs Always Deliver Average Performance

One of the most pervasive myths surrounding passive investing is also one of the most inexplicable given that it doesn’t stand up to even the most basic scrutiny.

In this case, we don’t even need to get bogged down in the theoretical merits of active versus passive investing, a brief look at the numbers will suffice.

If we take as an example the popular iShares Core S&P 500 ETF (CSP1), which tracks the S&P 500 index for an annual fee of just 0.07%. This fund has landed in the top decile when ranked against its US large-cap peers on a risk-adjusted basis over 3 and 5 year periods, this stellar performance can be extended out to ten years if we look at older funds which track the same index. It is clear this performance is anything but average.

And this is not an isolated example. If we look at our recently launched ETF ratings in Europe, which allow for direct comparison with active peers. Of the one hundred plus ETFs rated in Europe, 70 are Morningstar Medalists i.e. they are rated Gold, Silver or Bronze—our three positive ratings.

Of course, there are markets in which active managers have enjoyed greater success, but when considering any investment, it pays to disregard received wisdom and allow the numbers to speak for themselves.

Myth 2: All ETFs are Trackers

Although the vast majority of ETFs track an index, there are a small but growing number of active ETFs which do not.

When we talk about ETFs we are talking about a flexible investment vehicle that allows funds to be priced and traded throughout the day like a stock. This can be contrasted with the traditional priced-once-a-day mutual fund structure, which many see as archaic.

The transparency and rules-based predictability offered by index-tracking strategies makes them a perfect fit for the ETF structure. However, as the industry continues to grow, we shouldn’t be surprised if we see more and more active managers entering the market by repackaging their active strategies in an ETF wrapper.

Myth 3: Only ETFs Lend Securities

On more than one occasion, I have heard ETFs criticised for engaging in the ‘funny business’ of securities lending, which sees a percentage of fund holdings lent to a third party in exchange for a fee.

While securities lending is widely practised within physically replicated ETFs, it is actually traditional mutual funds, pension funds and insurance companies which are the biggest lenders of assets.

In fact, ETF providers in Europe are considerably more transparent than their active counterparts. They provide information relating to their lending activities, including on-loan levels, collateral guidelines, counterparties, on their websites.

Myth 4: Synthetic ETFs Hold Nothing

The confusion here is understandable given the history of swap-based ETFs in Europe.

While this statement may have held true for some ETFs in the past, it is no longer true for the bulk of ETFs on the market today. All major providers in Europe have now embraced a regulator endorsed structure in which a basket of highly liquid securities, such as top-rated government bonds and blue chip equities, sits on the fund’s balance sheet alongside the swap agreement.

Should anything untoward happen to the bank providing the index return, the fund has immediate access to the basket of securities, which can be sold as required. This, along with other measures, has gone some way to allay the fears surrounding counterparty risk in swap-based ETFs.

Source: Morningstar. Kenneth Lamont | 07/12/2016