ETFing Fun

ETFing Fun

“Passive investing” has been a popular topic among financial pundits for some time now. And it’s become a very popular topic for investors.

Even legendary value investor Warren Buffet has been quoted as saying that the best retirement plan is to put 10% of your capital in short-term government bonds and the remaining 90% in an ETF that tracks the S&P 500 index. Curious comments for a guy that’s consistently outperformed the market for so long.

Let’s take a step back to the bare basics for a moment… There’s essentially two ways to approach investing;

An “active” management approach is all about “beating the market” – actively managing capital with the goal of achieving an above-market return – “generating alpha”, as us finance nerds like to call it.

On the other hand, “passive investing” is all about accepting the market return.

It’s controversial stuff. The argument in favour of passive investing is that active investment managers don’t have a great track record of beating the market and they charge higher fees compared with passive investment managers. So why pay higher fees when it’s not a certainty that you will get a higher return?

The active argument is simply that it is possible to consistently beat the market – heaps of investors do – some being high-profile names overseeing big funds…some just average investors managing their own super fund.

But its here where the waters get muddy. Crucially, there’s a difference between “passive” and “buy and hold”. It can be the same thing, but “passive” need not mean “set and forget”.

In the past 10 years we’ve seen an explosion in the popularity of Exchange Traded Funds – “ETF’s”.

But we need to be careful about our interpretation of this.

Many commentators are eager to say this represents a revulsion of high-fee managers… That investors are by-passing professional managers and going it alone using ETF’s.

But it’s clear that ETF’s more commonly are being used as an investment tool within an active management approach.

In other words, the explosion of ETF’s doesn’t equal an explosion in “buy and hold” as a strategy… ETF’s have simply proven to be a very useful trading instrument.

Indeed, we use a lot of ETF’s within the Aviator Macro fund – they are everything they are marketed to be – a simple and inexpensive way to get exposure to a certain market. And with thousands of different ETF’s now offered globally, there’s basically one for every occasion.

ETF’s – a quick recap of the basics:

An ETF is an investment fund that is traded on a stock exchange in the same way as a company. The fund holds a portfolio of investments – shares, bonds, commodities or (most controversially) derivatives – and most commonly the fund is designed to track an index.

As an example, an ETF representing the ASX200 index holds a portfolio of shares that represent the index. This may take the form of holding all 200 companies in the same weightings as they are represented in the actual index or the fund managers may opt to hold the majority of index constituents.

The ETF’s value is derived from the value of the underlying portfolio. The most popular and trusted ETF’s are generally those that track the intended index very closely. Therefore, if a fund’s portfolio doesn’t fully replicate the underlying index, there’s a heightened risk of “tracking error” where their portfolio doesn’t perform the same as the index.

Instead of holding the physical securities, a “synthetic ETF” is an innovative variant to a physical ETF. The fund still intends to track an index however instead of holding physical securities it uses derivatives to track the index.

Most ETF’s are structured as open-ended funds. Units are created and redeemed via an “authorised participant” – generally being a major investment bank/brokerage firm – which acts as a market-maker by transacting in the ETF shares and also exchanging for ETF shares parcels of physical securities with the ETF issuer that represent the fund’s holdings (“creating” and “redeeming” ETF shares). This provides liquidity and aids in ensuring the ETF price accurately reflects the net asset value of the fund’s holdings.

Of course, given the exchange-traded nature of ETF’s, there are many that are now “optionable” – allowing access to exchange-traded call and put options.

Are you bearish on the Australian Dollar? Well, how about buying some Call options on the Proshares UltraShort Australian Dollar ETF…

The ETF is designed to yield a return twice the inverse of the AUD versus the USD. The ETF is therefore internally geared and, via the magic of options, investors can ratchet up the gearing to a whole new level!

The prevalence of ETF’s has got a few smart people worried.

According to S&P Dow Jones Indices, around US$10 trillion is tied to equities that make up the S&P 500 with over $3.4 trillion of this being in index ETF’s.

In the most basic sense, there’s a concern about whether ETF’s now have an outsized influence on the individual shares they represent – the “tail wagging the dog” so to speak.

A staggering number of shares in listed companies are now held by ETF’s – a fund which by definition has not purchased it based on solid fundamental research but merely because it happens to be part of an index that the ETF is seeking to mimic.

A staggering amount of investment capital is therefore being deployed not based on careful fundamental analysis but based on recent price performance and speculation of near-term future performance – momentum trading. Indeed, many attribute this to be at least partly responsible for many prestigious active management firms having difficulty out-performing these ETF’s in recent years – that fundamental analysis and stock selection is proving no match for momentum-chasing. This will be proven to be a short-term phenomenon in this late-stage bull market rather than the new normal.

Further, via their holdings, the ETF’s hold voting rights over staggering amounts of shares…with little regard for the financial performance of the company. I’m sure there are plenty of activist investors seeking to influence ETF managers on the way in which they cast their votes.

A lot of the big ETF’s boast deep liquidity in terms of shares traded on a daily basis. It’s inevitable that these have become instruments of choice for hedge funds and other major traders – some of course using computer-driven algorithms and leverage. So we have a market full of instruments designed to passively track other instruments, some featuring internal leverage, being used on a massive scale by fickle active managers that are in-turn often using leverage to enhance their returns.

What could possibly go wrong?

The IMF has warned on ETF’s posing a potential risk with respect to emerging markets. There’s now trillions of dollars in ETF products benchmarked against EM bond and equity indices. A lot of the money that has been invested in these funds is prone to quickly being pulled when sentiment shifts.

One of the “heroes” of the global financial crisis was an active manager called Michael Burry. He made billions betting against the US mortgage market and went on to be the subject of the book and movie “The Big Short”. Burry’s made some waves in finance-land in recent months by calling passive investing a “bubble”.

Burry sees similarities between ETF’s and the “collateralised debt obligations” (CDO’s) that did untold damage to the financial system during the GFC. He feels that the flow of passive funds are distorting prices in the same way that CDO’s did subprime mortgage prices and feels “it will be ugly” when flows reverse.

In a recent interview with Bloomberg he had this to say:

“The dirty secret of passive index funds – whether open-end, closed-end, or ETF – is the distribution of daily dollar value traded among the securities within the indexes they mimic. In the Russell 2000 Index, for instance, the vast majority of stocks are lower volume, lower value-traded stocks. Today I counted 1,049 stocks that traded less than $5 million in value during the day. That is over half, and almost half of those – 456 stocks – traded less than $1 million during the day. Yet through indexation and passive investing, hundreds of billions are linked to stocks like this. The S&P 500 is no different – the index contains the world’s largest stocks, but still, 266 stocks – over half – traded under $150 million today

“That sounds like a lot, but trillions of dollars in assets globally are indexed to these stocks The theatre keeps getting more crowded, but the exit door is the same as it always was. All this gets worse as you get into even less liquid equity and bond markets globally.”

“This structured asset play is the same story again and again – so easy to sell, such a self-fulfilling prophecy as the technical machinery kicks in. All those money managers market lower fees for indexed, passive products, but they are not fools – they make up for it in scale.”

“Potentially making it worse will be the impossibility of unwinding the derivatives and naked buy/sell strategies used to help so many of these funds pseudo-match flows and prices each and every day. This fundamental concept is the same one that resulted in the market meltdowns in 2008. However, I just don’t know what the timeline will be. Like most bubbles, the longer it goes on, the worse the crash will be.”

Some pretty provocative comments…

There seems to be two main arguments coming from the “ETF’s pose no issues” camp:

When you sell an ETF you’re selling proportionate amounts of the shares the ETF owns.
There’s no liquidity issue – its all just shares.

I feel this misses the mark in terms of how ETF’s and the market are interconnected. I think Michael has a real point in his comments above – there’s layer upon layer of strategies implemented around these products – there’s the products themselves, hedging strategies adopted by market makers and then trades with offsetting hedges applied by investors such as call/put options. All tied to shares that might not have nearly the liquidity needed to unwind these trades.

ETF’s equal passive investing equals “buy and hold”.

As described above, there’s a difference between passive investing and “buy and hold”. Seems some people aren’t fully grasping that ETF’s are not being bought by “buy and hold” investors – they are clearly being heavily traded.

Perhaps “bubble” is just not the right term to be using with the passive investing phenomenon. To finance guys, this term implies a huge valuation detachment from reality and a devastating bust lurking around the corner. It’s not at all clear that a damaging bust awaits – well, not one that can be specifically linked to ETF’s anyhow.

I’ve been saying for some time that the markets have become in my view increasingly fragile – largely as an outcome of central bank monetary policy and the desperate search for yield that near-zero interest rates have invoked. I’ve also stated that I do not believe monetary policy actions will “save” the market during the next economic downturn.

Will Michael Burry be right about a crash attributable to ETF’s and passive investing? My view is that the state of the ETF market absolutely has the capacity to add selling pressure in a downturn… maybe a lot. I’m not convinced that we will in hindsight be talking about ETF’s as having played a key role in a crash in the same way as CDO’s did during the financial crisis.

That old Mark Twain saying is probably apt in this instance – “history doesn’t repeat itself, but it often rhymes”.