Sour grapes.
That’s how a whole helluva lot of people are characterizing the cat calls from the active management community, which has recently turned up the volume on what amounts to a coordinated warning on the dangers posed by the rampant proliferation of ETFs and other low-cost, passively managed investment vehicles.
To be sure, the sour grapes argument probably has some merit. Because you know, active managers like their outsized expense ratios. And when it comes to the “2 and 20” crowd … well … for fuck’s sake, don’t investors realize that good coke and Perrier-Jouët is expensive? I mean shit, you can’t fund a weekend of debauchery in the Hamptons by charging people 10 basis points. Jesus.
That said, it’s starting to feel like the folks who had the most to lose from the rise of passive investing have resigned themselves to their fate and are now genuinely concerned about what it means for markets when trillions of dollars is being thrown indiscriminately at benchmarks by way of what amount to derivatives that no one seems to realize are in fact derivatives.
This is dangerous for all manner of reasons from the rickety creation/destruction mechanism that everyone assumes is actually a streamlined miracle of financial engineering to the fact that some ETFs (most notably high yield corporate bond funds) are giving investors the illusion of liquidity when in fact the market for the underlying assets is anything but liquid. And then there’s the misallocation of capital argument.
We have of course talked about all of this ad nauseam in these pages. Here’s a set of charts that demonstrates the epochal shift outlined above:
(BofAML)
And then here are some more charts rendered in pleasing hues of blue:
(Goldman)
Well, the latest (and perhaps the most hyperbolic) warning about ETFs comes from Arik Ahitov and Dennis Bryan, who run the $789 million FPA Capital Fund.
Consider the following (full) excerpts from a letter dated earlier this month:
Are ETFs the new weapons of mass destruction?
Notwithstanding any of the concerns mentioned above, investors appear excited about the future as they continue to pour money into the stock market. They express this excitement by allocating a tremendous amount of capital into index funds and Exchange-Traded Funds (ETFs). Last year, passive funds had $563 billion of inflows, while active funds experienced $326 billion of outflows, according to Morningstar. Active U.S. equity funds manage $3.6 trillion and passive instruments are about to catch them at $3.1 trillion. When we add the $124 billion poured into ETFs in the first two months of 2017, active and passive investments are almost at parity. This does not even include the so-called active managers that tend to hug an index. The long-term trend is very pronounced. Since 2007, $1.2 trillion dollars disappeared from actively managed U.S. domestic equity funds and $1.4 trillion dollars were added to passive strategies. As the number of corporate listings continues to dwindle, more and more ETFs are brought to the marketplace. This leads to more ETFs (financial vehicles), some of which use leverage, chasing fewer and fewer actual companies. Financial vehicles using leverage to purchase a shrinking pool of real assets–sound familiar?
The consequence of unrelenting inflows into passive funds is that stocks that are included in a major index receive ongoing support by the indiscriminate purchases made by these funds regardless of a company’s fundamentals. The benefits are amplified for companies that are owned by dozens of ETFs and index funds. On the flip side, those unfortunate stocks that are not included in a major index receive the reverse treatment, as active managers that tend to be fully invested are forced to sell shares to meet the onslaught of redemptions they are facing. But the worst fate is saved for those orphan securities that are removed from an index. These stocks face both indiscriminate selling from index funds on their removal date and continued redemption-related selling from actively managed funds. Unfortunately, these buy and sell decisions are entirely disconnected from a company’s fundamentals. This potentially sets the stage, should the tables turn, for an exceptionally compelling investment environment where companies with strong fundamentals are available for purchase at cheap valuations for those searching outside of the indices (as we often are). Moreover, as more investors move from active to passive investments, the market for many individual stocks becomes less liquid. With reduced liquidity, we expect increasing volatility in the marketplace. Last month Kopin Tan wrote in Barron’s, “For weeks, the stretch from 3 p.m. to 4 p.m. became known as the market’s happiest hour, since a surge in late-day buying often nudged indexes from the red into the green. This happened because ETFs and passive index funds, unlike actively managed ones, must rebalance by the end of the day to match the benchmarks they track. According to JP Morgan, a whopping 37% of daily New York Stock Exchange trading recently took place in the last 30 minutes of each session. But when the indexes turn down, will this be the unhappiest hour?”
The weapons of mass destruction during the Great Financial Crisis were three-letter words: CDS (credit default swap), CDO (collateralized debt obligation), etc. The current weapon of mass destruction is also a three-letter word: ETF (exchange-traded fund). When the world decides that there is no need for fundamental research and investors can just blindly purchase index funds and ETFs without any regard to valuation, we say the time to be fearful is now.
There you go.
That echoes everything we’ve been saying since the inception of this site late last year.
So when this whole thing crashes and burns in some kind of nightmarish August 24, 2015 redux (except on steroids), don’t say you weren’t warned.
On the bright side, once these ETF “WMDs” reduce the market to ashes, active management can swoop back in and try to help everyone pick up the pieces.
And once everyone learns their lesson and the active AUM starts to climb again, the “rockstars” can get back to racing two-door Maseratis while coked up with three women crammed into the backseat and a half-empty bottle of Johnny Blue riding shotgun.
Then all will be right with the world.
Yours truly,
So what’s the ETF equivalent to the CDS/CDO Insurance?