At the risk of turning Monday into “Heisenberg’s anti-ETF crusade” day, I’m going to show you one more reason why the rampant proliferation of ETFs is probably a bad idea.
Note that this comes with all the usual caveats about the growth of low-cost vehicles generally being a positive development.
One of important things to note about those who claim that the out-of-control growth in ETFs is not only acceptable, but in fact desirable, is that their claim hinges to a large extent on an unassailable position that owes its unassailable character to the rising central bank tide that lifts all benchmarked boats.
That is: “sure, replicating a benchmark for 10 basis points is great when the benchmark isn’t allowed to fall.” You can’t argue with that and indeed, no one is trying.
Arguments against the proliferation of ETFs are far more nuanced. You can read a great explanation of some of the technical issues in a guest post published here earlier today.
When you consider what you’ll read from Goldman below, think back to “Behold: One More Way ETFs Are Distorting Markets,” in which I explained that HY bond ETFs are disproportionately funneling money to large capital structures by virtue of the ETFs’ benchmark-replicating mandate.
In the same vein, here’s Goldman to explain how S&P ETFs are facilitating the misallocation of large amounts of capital.
Passive investing, led by ETF growth, has delivered superior returns at lower fees (in many cases) than active managers over the last decade. If the best measure of success in an investing world is performance (return per unit of risk) one other indicator would be AUM growth. Indeed the growth in these products, as seen below, has been unabated.
With the runaway growth of these products we ask if following an index is the optimal allocation for capital. Namely we run an analysis juxtaposing the ROIC v WACC of the S&P 500 by weights of the underlying stocks. We find that it is not.
There appears to be no direct relationship between a company’s ROIC/WACC and its weight in the S&P 500..
ROIC / WACC for the top 10 companies in the S&P 500 (20% of the index), on average, is lower than that of the next 70 companies.