Are ETFs a bubble?

Recently, there have been reports going around in the media criticizing passive investing and warning of ETFs. Among the authors of these negative news can be found not only legendary investors, but also Slovak brokers. Do investments in ETFs really carry a higher risk? Finax has built the portfolios on these great tools, so we see it as our duty to clarify this matter.

Radoslav Kasík | Investment academy | 27. November 2019

Michael Burry, a legendary investor who foresaw the mortgage crisis of 2008, is at the forefront of warnings of the index ETFs.

He is among the few people that identified the economic catastrophe in the form of credit default swaps (CDS) and he was able to earn money from their collapse. His name also became famous for the great film The Big Short, starring Christian Bale as Burry.

Although the media slightly twisted his statement, Michael Burry criticized the ETF for deteriorating pricing in markets, investors overlooking smaller companies' stocks due to passive investing, and the use of derivatives to replicate market developments.

Negative statements regarding index ETF can also be found in our region on several sites dealing with finances and investments, among some financial agents, but certain Slovak investment firms have also been wary of them.

So, let's look at what they are actually warning us about, what they consider as drawbacks of passive investing, what risks they point out and whether they represent any real threats.

ETFs are a bubble

By its very nature, this statement does not make sense. ETFs cannot be a bubble. It is an investment tool that only invests the shareholders' assets in various classes of securities, such as stocks, bonds or, as the case may be, derivatives. ETFs buy exactly the same securities as individual investors or professional managers of actively managed funds.

Bubbles can only exist on specific asset classes, not on funds that invest in them. If ETFs were a bubble, the whole market would have to be a bubble, i.e. actively managed mutual funds would also be affected and would also be subjected to the risk of overvaluing the prices of held assets.

We can therefore only discuss in general whether stocks and bonds are in a bubble, or whether they are overvalued. Today, however, we focus on the potential threats and drawbacks of ETFs, not on the price levels of individual assets.

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It is ironic when equity mutual fund managers call equity index funds a bubble. It is the same as looking forward to not being hit by rising oil prices because you have a diesel, not a petrol engine.

ETFs are changing and distorting the market

The drawback, often mentioned in regard to ETFs, is their negative impact on the functioning of financial markets. The basic principle of markets is to match the opposing expectations of investors, which creates objective asset prices.

One participant assumes that the stock price will fall and considers it expensive. The other investor expects it to rise and considers it to be undervalued. The stock market combines these two opposing perspectives and sets the price at which the former is willing to sell and the latter to buy, thus the trade is realized. Pricing is a fundamental role of the market.

Passive funds are accused of pushing this principle out of the markets. Passive investors do not evaluate specific assets and do not forecast their development. They simply make use of all the titles that are available on a given market, regardless of their price, which allegedly eliminates opposing expectations from the market, thus also removing the counterparties of the trade.

The growing popularity of passive investing should thus distort the evaluation of assets, as it does not take into account fundamentals. Index funds are pushing objective pricing out of the market.

However, these statements are not supported by facts at all. Firstly, the volume of trades made on stock exchanges did not decrease due to the expansion of index ETFs. So far, there have been no liquidity problems, e.g. sellers would have trouble finding buyers for their securities.

The following chart depicts the development of the stock index of the large US companies S&P 500 over the past 20 years. The bottom part of the chart, highlighted in a red rectangle, shows the volume of traded stocks. It is clear that the volumes did not decrease significantly with the expansion of ETFs, on the contrary, they have multiplied in the last two decades.

The share of ETFs in US stock ownership, where this financial tool has experienced the biggest gains in popularity, is still not large enough to have a significant impact on the market. According to Goldman Sachs it was around 6% in 2017. Other sources estimate the share of passive funds in stock ownership to be up to 14%, which is still not very significant.

Households, mutual funds, pension funds and foreign investors own significantly more stocks than passive tools. Market power still remains in the hands of active investors, who ensure sufficient pricing in the markets.

When assessing the impact of ETF industry on the efficient functioning of markets, other factors have to be taken into consideration. ETFs are not only about basic value-weighted indices, but they also focus on multiple specific asset classes. Today, the ETFs offer a broad and diverse package of tools in terms of investment orientation.

There are numerous types of these funds, example being sector or thematically oriented ETFs, funds representing factor investing (Smart Beta funds that track indices, build using various qualitative and quantitative parameters of securities) and others.

ETFs investors do not behave in a unified, herd-like way, in comparison to the way they are portrayed by critics. They also have opposing expectations and prefer different sectors, regions or investment selection parameters. While some sell investments, others buy. Investing in ETFs does not represent a single, identical group of investors.

Real reasons for liquidity problems in markets?

Even if there is some decline in trading volumes on the US stock exchanges, ETFs are not the cause of it. Bank regulation is the main reason for reduced liquidity. In the past, banks held large volumes of stocks and bonds in their own books. They represented the so-called market makers and provided the necessary liquidity to the market.

Tightening of regulation and increasing capital requirements has made it disadvantageous for banks to hold risky securities on their balance sheets. The necessary liquidity has therefore disappeared from the market, which is then noticed in volatile periods, when banks provided a cushion to mitigate price movements.

Today, a large part of the traded stocks volumes stems from the so-called high frequency traders. These are various funds, speculators and banks that algorithmically do thousands of trades in a short time with the goal of achieving numerous very small profits.

Although these entities supply the market with necessary liquidity and replace market makers in quiet times with increased volatility, they usually switch off or make use of trends, which only exacerbates the volatility and does not compensate for the liquidity shortfall.

If regulators and investors want to address the pricing and liquidity issues, they should focus primarily on the real reasons for these potential problems. Currently that does not include the ETFs.

Forgotten stocks of small companies

The development of the volume of trades does not show the neglect of stocks of small companies. The following chart depicts the development of the US stock index Russell 2000, which is composed of shares of small companies with a value of up to 2 billion dollars.

The bottom part of the chart, as in the S&P 500 index chart above, depicts volume of the traded index's stocks. Obviously, even in this case, trade volumes have not decreased in recent years. Based on this chart, the statement that investors would ignore smaller titles due to the popularization of ETFs is not true.

The US stock market is clearly not more concentrated than it was in the past, despite the ongoing acquisition activity, i.e. mergers and takeovers of traded companies.

The investments of active managers are more concentrated

When talking about the concentration of capital in the markets, it is interesting to have a look at the investment behaviour of the active managers, who are currently criticizing the ETFs and the market concentration caused by passive investing.

A few months ago, the Swiss bank UBS published the most popular stocks among active managers in the world. The leader is Alphabet (Google, the 3rd largest company in the S&P 500 index), Visa (10th), Adobe (35th), Microsoft (1st) and MasterCard (17th).

Several sources state (e.g. Michael Batnick via Barron’s) that large active managers have a bigger share of assets under management allocated to the largest stocks in the index than is the share of those stocks in the indices.

What does it mean? Active managers have portfolios allocated in large stocks more than what their weight in indices is, meaning their portfolios are more concentrated than the market itself. What they criticize the passive investing for, they do much more. The pot calling the kettle black?

What are the drawbacks of ETFs?

Despite the prevailing and undeniable benefits that ETFs offer to investors, like with any new financial phenomenon, the potentially negative side effects are still present. It can also be assumed that full effects of passive investment will be discovered only in the future.

The clear benefits of ETFs, which make them the best investment tool, include, in particular, significantly lower fees, widespread risk and the reduction of human factor risk as the greatest investment risk. This results in higher long-term returns, which are the reason for their current success.

The negative, that I am mostly concerned about, is the disappearance of corporate governance among administrators and investors. Corporate governance can be understood as the strategic thinking and management of the company by its owners.

An undeniable benefit of active asset management is the participation in the management of co-owned companies. The goal of the investor holding the company's stocks is to increase its value, i.e. the company's income and profitability.

A significant share of the company's ownership provides voting rights and influence over management. If a shareholder has an idea that will be beneficial for the business, they will try to enforce it. In this case, the investor can guide, control, motivate, but also put pressure on company's managers.

Majority of active investors and portfolio managers of large funds have the knowledge and experience to be able to properly set up companies for greater success. The corporate governance has usually a positive economic impact and the contribution of active managers in this respect is undeniable.

The second unfavourable externality, that has to be considered, may be the increase in market volatility (fluctuations) due to the greater share of index funds in trading. So far, however, I have not come across any relevant research that would confirm this hypothesis.

Even if investors behave en masse, I do not consider this to be a significant risk. It would result in faster and greater fluctuation of the indices, i.e. the market price would fluctuate more around the intrinsic value, but the final long-term efficiency of the markets would remain the same.

Higher volatility can also be seen as an opportunity. Once again, we can see another example of the irony of active managers criticising passive investing.

If, as a result of its increase in popularity, major anomalies would appear in the markets, i.e. asset prices become more overvalued or undervalued, active managers should be able to detect these price discrepancies more easily.

Therefore, they should find it easier today to find the right trades and investments, i.e. to achieve higher returns and outperform market appreciation, but that is not the case.

What to look out for in ETFs?

Although ETFs are currently an unrivalled investment tool, there are several things that you to be aware of.

The two most important factors when selecting a particular ETF are the method used to track (replicate) the index and the assets under management.

Even Michael Burry pointed out the so-called synthetic ETF. These funds track the performance of the underlying indices usingderivatives. They usually buy safe bonds into the portfolio and copy the development of the index using swaps.

There are few such ETFs in the world. In addition to market risk (index development), you also bear the credit risk of the derivative and bond issuer. In the past, Lehman Brothers were an icon in the derivatives market, which eventually defeated them. If ETFs held swaps issued by them, passive investors would be in for a surprise when they bankrupted.

The derivatives market poses a persistent threat to global financial markets, mainly due to its size. It can multiple the value of a single security, which is then transferred between the balance sheets of banks and financial institutions.

Therefore, the so-called physically replicating funds should be preferred, as they physically purchase the assets that make up the underlying index, or as the case may be, slightly simplify the composition (reduce the number of titles). For example, in the case of an S&P 500 index fund, they include exactly all 500 stocks making up the index.

Subjective qualities of the investment include the focus of the fund itself, factor investment or the payment of dividends. However, here we are already talking about specific investment preferences and strategies.

In this regard, we are in favour of traditional passive investing, which should to be widely diversified, focused on the whole world and taking into account the distribution of market value within it. We are not fans of Smart Beta funds. Higher costs are associated with them and they usually reduce volatility, i.e. increasing the risk, and on top of that offer a lower long-term return.

When creating Intelligent Investing portfolios, we have taken into account all the above-mentioned aspects. You can find more information on how and based on which criteria have we selected specific ETFs in this article.

We believe that there is nothing to worry about ETFs. Their benefits and advantages significantly outweigh a few potential drawbacks. As I have shown, much of their criticism is unfounded and, above all, unjustified.

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If you want to appreciate your savings as much as possible, and you are not a professional investor, ETFs are the best choice for you. All the negative news about this industry is mainly an attempt to discredit it and hide the inability of active managers to surpass the market or prevent money from leaving their management.

Passive investing must be the cornerstone of healthy personal finances and long-term asset building. Only when you have acquired sufficient assets with this approach, can you start thinking about other investment alternatives that carry a higher risk and represent a certain adventure for your money.

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