When ‘Trillions Of Dollars’ Goes ‘Blind’: Howard Marks Is Worried About ETFs & Passive Investing

When ‘Trillions Of Dollars’ Goes ‘Blind’: Howard Marks Is Worried About ETFs & Passive Investing

As a product of the last several years, ETFs’ promise of liquidity has yet to be tested in a major bear market, particularly in less-liquid fields like high yield bonds.

That’s from Howard Marks and it echoes something he’s been saying for years. Namely that an ETF promises intraday liquidity even as in many cases the assets underlying the ETFs are not in fact liquid.

As Marks put it back in 2015:

The ETF can’t be more liquid than the underlying, and we know the underlying can become highly illiquid.

That is the very foundation of my criticism with regard to HY and EM bond ETFs. It is philosophically impossible for something to be more liquid than what it represents and no amount of “volume” in the ETF units is going to change that. It doesn’t matter how “well behaved” the NAV basis is and similarly, it doesn’t matter how “efficient” you imagine the underlying mechanics are. When push comes to shove (and it will), someone, somewhere, is going to have to transact in the underlying bonds and if they aren’t liquid, well then neither is the ETF.

In short, ETFs are funneling retail money into corners of the market where that money has no business being unless it’s overseen by a professional.

But the problems with ETFs (and passive investing more generally) aren’t confined to vehicles that suffer from an inherent liquidity mismatch. ETFs by definition encourage herding and indiscriminate buying. It stands to reason that if the buying is indiscriminate on the way up, the selling will be similarly indiscriminate on the way down.

Indiscriminate capital allocation invariably (indeed, by definition) leads to misallocated capital. It also encourages mindless participation in markets and discourages analysis. Recall this from Goldman:

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.


And make no mistake, the active-to-passive shift is becoming more pronounced by the year:


Indeed, as we wrote just a few days ago, we’ve entered what Deutsche Bank aptly calls “uncharted territory in ETF land” with inflows in H1 2017 very nearly outpacing inflows for any other full year on record:


Further, as we’ve documented extensively, we’re getting pretty far afield at this point with regard to what counts as “passive.” The more “focused” these vehicles get on factor-based strategies or worse, on things that are just outright absurd (remember “Long Jesus?” and/or the “Quincy ETF“?), the more managers are charging presumably to justify the selection of securities. That effectively negates one of the main benefits of “passive” investing. Recall what we wrote earlier this month about the new “FANG ETF“:

Well on Wednesday we got AdvisorShares “New Tech and Media ETF”, which trades under the ticker “FNG.”

Now first of all, the ticker is a rather blatant attempt to lure investors by promising exposure to the most recognizable acronym in the world. And what’s especially silly about that is that the question any reasonable person would immediately ask is this: “why wouldn’t I just by FANG stocks?”

That question becomes even more relevant when you have a look at FNG’s expense ratio, which is a whopping 0.85%:


Of course AdvisorShares isn’t going to come out and tell you that they’re charging you 85bps to put your money in stocks you could just buy yourself.

No, they’ll justify the fee by explaining how their “active” strategy will be nimble enough to “evolve” with the market.

That didn’t sit well with AdvisorShares boss Noah Hamman:


Sorry about that, Noah.

Oh, and don’t forget about the fact that “super firms”, by virtue of their size and influence at the benchmark level, are becoming synonymous with a number of the “factors” behind the “factor-based” strats. That’s creating strange scenarios where, for instance, tech stocks are suddenly heavily weighted in low vol. vehicles.


Again, these are all concerns we have raised over, and over, and over in these pages.

But don’t take our word for it, just ask the above-mentioned Howard Marks, whose latest note underscores quite literally everything said above (in some cases he literally references the same funds we’ve talked about). Enjoy…

Via Howard Marks

Fifty years ago, shortly after arriving at the University of Chicago for graduate school, I was taught that thanks to market efficiency, (a) assets are priced to provide fair risk-adjusted returns and (b) no one can consistently find the exceptions.  In other words, “you can’t beat the market.”  Our professors even advanced the idea of buying a little bit of each stock as a can’t-fail, low-cost way to outperform the stock-pickers.

John Bogle put that suggestion into practice.  Having founded Vanguard a year earlier, he launched the First Index Investment Trust in 1975, the first index fund to reach commercial scale.  As a vehicle designed to emulate the S&P 500, it was later renamed the Vanguard 500 Index Fund.

The concept of indexation, or passive investing, grew gradually over the next four decades, until it accounted for 20% of equity mutual fund assets in 2014.  Given the generally lagging performance of active managers over the last dozen or so years, as well as the creation of ETFs, or exchange-traded funds, which make transacting simpler, the shift from active to passive investing has accelerated.  Today it’s a powerful movement that has expanded to cover 37% of equity fund assets.  In the last ten years, $1.4 trillion has flowed into index mutual funds and ETFs (and $1.2 trillion out of actively managed mutual funds). 

Like all investment fashions, passive investing is being warmly embraced for its positives: 

  • Passive portfolios have outperformed active investing over the last decade or so.
  • With passive investing you’re guaranteed not to underperform the index.
  • Finally, the much lower fees and expenses on passive vehicles are certain to constitute a permanent advantage relative to active management.

Does that mean passive investing, index funds and ETFs are a no-lose proposition?  Certainly not:

  • While passive investors protect against the risk of underperforming, they also surrender the possibility of outperforming.
  • The recent underperformance on the part of active investors may well prove to be cyclical rather than permanent.
  • As a product of the last several years, ETFs’ promise of liquidity has yet to be tested in a major bear market, particularly in less-liquid fields like high yield bonds.

 Here are a few more things worth thinking about: 

Remember, the wisdom of passive investing stems from the belief that the efforts of active investors cause assets to be fairly priced — that’s why there are no bargains to find.  But what happens when the majority of equity investment comes to be managed passively?  Then prices will be freer to diverge from “fair,” and bargains (and over-pricings) should become more commonplace.  This won’t assure success for active managers, but certainly it will satisfy a necessary condition for their efforts to be effective.

One of my clients, the chief investment officer of a pension fund, told me the treasurer had proposed dumping all active managers and putting the whole fund into index funds and ETFs.  My response was simple: ask him how much of the fund he’s comfortable having in assets no one is analyzing.  

As Steven Bregman of Horizon Kinetics puts it, “basket-based mechanistic investing” is blindly moving trillions of dollars.  ETFs don’t have fundamental analysts, and because they don’t question valuations, they don’t contribute to price discovery.  Not only is the number of active managers’ analysts likely to decline if more money is shifted to passive investing, but people should also wonder about who’s setting the rules that govern passive funds’ portfolio construction.

The low fees and expenses that make passive investments attractive mean their organizers have to emphasize scale.  To earn higher fees than index funds and achieve profitable scale, ETF sponsors have been turning to “smarter,” not-exactly-passive vehicles.  Thus ETFs have been organized to meet (or create) demand for funds in specialized areas such as various stock categories (value or growth), stock characteristics (low volatility or high quality), types of companies, or geographies.  There are passive ETFs for people who want growth, value, high quality, low volatility and momentum.  Going to the extreme, investors now can choose from funds that invest passively in companies that have gender-diverse senior management, practice “biblically responsible investing,” or focus on medical marijuana, solutions to obesity, serving millennials, and whiskey and spirits.  

But what does “passive” mean when a vehicle’s focus is so narrowly defined?  Each deviation from the broad indices introduces definitional issues and non-passive, discretionary decisions.  Passive funds that emphasize stocks reflecting specific factors are called “smart-beta funds,” but who can say the people setting their selection rules are any smarter than the active managers who are so disrespected these days?  Bregman calls this “semantic investing,” meaning stocks are chosen on the basis of labels, not quantitative analysis.  There are no absolute standards for which stocks represent many of the characteristics listed above. 

Importantly, organizers wanting their “smart” products to reach commercial scale are likely to rely heavily on the largest-capitalization, most-liquid stocks.  For example, having Apple in your ETF allows it to get really big.  Thus Apple is included today in ETFs emphasizing tech, growth, value, momentum, large-caps, high quality, low volatility, dividends, and leverage. 

Here’s what Barron’s had to say earlier this month:

With cap-weighted indexes, index buyers have no discretion but to load up on stocks that are already overweight (and often pricey) and neglect those already underweight.  That’s the opposite of buy low, sell high.

The large positions occupied by the top recent performers — with their swollen market caps — mean that as ETFs attract capital, they have to buy large amounts of these stocks, further fueling their rise.  Thus, in the current up-cycle, over-weighted, liquid, large-cap stocks have benefitted from forced buying on the part of passive vehicles, which don’t have the option to refrain from buying a stock just because its overpriced. 

Like the tech stocks in 2000, this seeming perpetual motion machine is unlikely to work forever.  If funds ever flow out of equities and thus ETFs, what has been disproportionately bought will have to be disproportionately sold.  It’s not clear where index funds and ETFs will find buyers for their over-weighted, highly appreciated holdings if they have to sell in a crunch.  In this way, appreciation that was driven by passive buying is likely to eventually turn out to be rotational, not perpetual. 

Finally, the systemic risks to the stock market have to be considered.  Bregman calls “the index universe a big, crowded momentum trade.”  A handful of stocks — the FAANGs and a few more — are responsible for a rising percentage of the S&P’s gains, meaning the stock market’s health may be overstated.  

All the above factors raise questions about the likely effectiveness of passive vehicles — and especially smart-beta ETFs.  

  • Is Apple a safe stock or a stock that has performed well of late?  Is anyone thinking about the difference?
  • Are investors who invest in a number of passive vehicles described in different ways likely to achieve the diversification, liquidity and safety they expect?
  • And what should we think about the willingness of investors to turn over their capital to a process in which neither individual holdings nor portfolio construction is the subject of thoughtful analysis and decision-making, and in which buying takes place regardless of price?

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