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The underestimated risks of ETFs and passive investing

December 16, 2019 | ETFs

Anyone thinking about investing today will sooner or later come into contact with ETFs – exchange-traded funds. In most cases, these are exchange-traded funds that imitate a share index such as the DAX or S&P 500. A whopping 5.5 trillion US dollars have now flowed into this form of investment worldwide, and the trend is rising.

What is it that makes this form of investment so attractive and what are the risks for the economy as a whole?

Low costs for below-average performance

The most powerful argument in favour of ETFs is their low fees. As this form of investment simply replicates an existing index, there is no need for a fund manager to selectively invest in individual shares or other securities. This saves the costs of the manager’s work.

ETFs also allow smaller investors to invest in a wide range of different shares in one go. This means that investors do not have to put all their eggs in one basket and can diversify their portfolio.

ETFs are basically a plausible way of investing in different companies and markets as cheaply as possible in order to achieve a performance in line with the market (i.e. average). Average is not a bad thing per se – in a good stock market year, solid returns are possible in this way. But as ETFs merely track other indices, they will never outperform them – if you factor in the fees, the performance actually falls below the average.

Of course, this also applies if the markets collapse. Then your portfolio will also suffer, and to the same extent as the market. As there is no fund manager actively pulling the strings in the background, but the corresponding index continues to be rigidly mapped in this scenario due to the business model, there is no damage limitation in ETFs.

ETFs damage the economy as a whole

The passivity of ETFs also creates an unpleasant side effect that could harm the economy in the long term.

This is because ETFs are shareholders in the companies in which they invest. Of course, this also means that they have voting rights at the annual general meetings of these companies. These events are an important vehicle for public companies to vote on issues such as management remuneration, bonus packages or improvements in corporate governance. A study has shown that ETFs are similarly passive in exercising their voting rights as they are in their investments, and in the vast majority of cases they vote in favour of the company management. Why would they want to change anything? The fact that ETFs only track an index and do not have to outperform it means that there is no incentive to ensure that companies continue to develop.

Considering that more shares are now held by passive funds than by active funds, this passivity could have a negative impact on the relevant companies in the long term. And although not every active fund manager makes direct use of their voting rights, they do so on a daily basis in another way – by letting companies know how they rate them through buying and selling.

The underestimated danger of ETFs

We certainly don’t want to talk down ETFs. This form of investment can make sense for many investors. However, it is important to bear in mind that there are a large number of companies in an index that are not doing very well. These are either companies that are barely growing and are completely overvalued (due to the constant passive purchases of ETFs), or perhaps even companies that are already no longer earning money and will be in a very bad position in the near future.

As long as investors “blindly” buy everything via ETFs, these companies will continue to be “carried along” in their valuations. Particularly in extreme times of ultra-loose monetary policy, this encourages an inflation of this situation – until there is a major setback and investors withdraw their money all at once.

Healthy companies that are growing and earning a lot of money are dragged down with them. But as soon as the situation calms down, the active managers see their chance to get their hands on the good companies at extremely favourable prices. The overpriced or ailing companies (which are now priced normally at best) will not be bought – except by the ETFs. You can read how this can end for an ETF buyer here in the short article “Good is not good enough for us“.

We want to be better than the average

We are convinced that our strategy of value investing will enable us to achieve above-average returns over the long term and thus outperform comparable indices. This is precisely what our portfolio managers are world-class at – the careful selection of undervalued and strong companies. They prove this year after year.

Outstanding companies at a discount price

The basic principle of value investing is simple: we buy shares in companies whose current or expected price is lower than their value. According to Warren Buffett’s motto:

"The price is what you pay. The value is what you get."

In the long term, we assume that the price (= share price) will adjust to the actual value of the company and that the share price will rise (details on our value investing strategy can be found here).

Thanks to the low minimum investment amount of € 20,000, we are also enabling smaller investors to benefit from our sustainably successful investment strategy for the first time.

What’s important to you?

Ultimately, the decision is up to you. If you are satisfied with an average return, ETFs with their low fees are a legitimate option.

Or you can rely on the skills of our fund managers, who use the proven value investing strategy to achieve above-average performance through selective stock picking.

How do you decide?

Estably is the first digital asset management company from Liechtenstein to offer first-class wealth management from € 20,000 through a mix of technology and human investment expertise. Thanks to the portfolio managers' many years of experience in the field of value investing, above-average returns are targeted. This is intended to make professional asset management, previously available exclusively to large investors, accessible to everyone - conveniently, transparently, and profitably.

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