We’ve said this before and to be sure, it’s not a popular thing to say if you’re hanging out with retail investors or anyone who isn’t an active manager, but fuck it, we’re going to say it again anyway: the democratization of investing, facilitated in no small part by the rampant proliferation of exchange-traded products, has gone too far.
This is a classic case of a situation where the backlash against an inherently self-serving, and increasingly nefarious business model (in this case active management) is overdone.
While it’s certainly a positive development that investors have access to low-cost vehicles that help “the little guy” bypass greedy money managers who may or may not be putting their own interests ahead of clients’ interests, we’ve reached a point where the risks are starting to outweigh the benefits.
There are myriad concerns with the continued growth of exchange-traded products including, but certainly not limited to: their still unknown effect on liquidity, the extent to which they promote indiscriminate buying/selling, the possibility that something will go wrong in the creation/destruction mechanism in a pinch, the fact that they allow retail investors to access esoteric corners of the market where those investors probably have no business being, the fact that some vehicles are pseudo-futures, and on, and on, and on.
Here’s what we said earlier this year:
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 and EM 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.
Well, with all of that in mind, consider the following brief bit from Deutsche Bank, whose Sebastian Mercado notes that we have entered “uncharted territory in ETF land” with inflows in H1 2017 very nearly outpacing inflows for any other full year on record.
Don’t just skim the following – take a second to actually internalize it…
Via Deutsche Bank
First, let us begin by pointing out that we have entered uncharted territory in ETF land – at least when it comes to flows.
As you may remember from previous reports, we have discussed extensively the seasonal nature of ETF flows as an industry in the US, which usually begin discrete on Q1 and end up on a high note on Q4. Nevertheless, this year we have already accumulated $245bn billion on the first half (H1) of 2017 with the addition of $113bn of inflows during Q2. Just to put this into perspective, $245bn would be the second largest full year for ETP inflows, just behind 2016 when the record was set at $283bn for the full year figure. Nevertheless there is still one full half ahead, which usually tends to be the strongest one.
Historically, in the last 10 years H1 ETP flows have represented between 11% and 48% of the full year flows (all halves have been positives), with an average of 32%. And if history provides any guidance, I would say that it is unlikely that H1 inflows will tilt towards the lower end of the historical levels. Most likely, we believe that H1 flows will represent between 32% and 48% of the full year flows, this would suggest that full year inflows could be anywhere between $500bn and $750bn for the current year, in the absence of any significant market pullback (>10%).
Now is probably a great time to reprint the following full letter out earlier this year from Arik Ahitov and Dennis Bryan, who run the $789 million FPA Capital Fund.
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.
