“When S&P 500 returns were worse than -6%, we calculated the average of the following three months ETF flows”, Toroso wrote, back in early 2018 when things were starting to crack following the post-tax-cut melt-up that preceded “Vol-pocalypse”.
“Negative returns have actually been beneficial for ETF flows!”, they went on to exclaim.
Little wonder. If someone asked you to name two trends or themes that have played an important role in shaping the post-crisis investment landscape, among the first to pop into your brain would likely be the active-to-passive shift and investors’ propensity to buy the dip.
In August, assets in US equity index funds passed those held in active funds for the first time, marking the culmination of an epochal shift years in the making.
That helps explain why the stocks of the companies which created the indexes tracked by passive vehicles have performed so well. The more popular indexing gets, the more money allocated to index funds. And the more money pegged to the indexes, the more revenue for their namesakes.
When you combine the two themes mentioned above (the popularity of passive investing and dip-buying) you’re left to ponder whether a significant drawdown for equities might actually be a wholly positive development for ETF providers.
In keeping with the Toroso study cited here at the outset, it won’t surprise you to learn that ETF flows have been strong in and around some of the more harrowing episodes for markets in the post-crisis period. Have a look:
(Adapted from BBG data, as originally presented by Vildana Hajric here)
The overarching message: Pullbacks are good for business if you’re an ETF provider. They’re not so great for active mutual funds, though.
If you think back to December of 2018, the “retail flush” manifested itself most prominently in outflows from mutual funds. “The situation changed dramatically last week after the S&P 500 broke out of its trading range”, Barclays wrote on December 22, 2018, noting that the previous week saw outflows of nearly $40 billion, “mainly from mutual funds, rather than from ETFs”.
The last thing anyone wants during a drawdown these days is to lose money and pay high fees to do it. So when it comes to dip-buying on a big selloff, you can bet ETFs will benefit from mutual fund malaise.
Consider this quote from Vanguard’s Rich Powers (this is from the linked Bloomberg piece above, but Powers made the comment at a conference last month):
We know the market’s going to trend down at some point and it could be the next wave — it could catalyze the next wave — of ETF adoption. [The crisis was] one of the great catalysts for the adoption and acceleration of ETFs.
Ironically (and happily), these flows have played a big role in keeping volatility at bay. “Equity volatility was severely dampened by technical factors [in 2019] like the massive gamma supply, ever stronger corporate buybacks and the significant rise in passive investment”, SocGen said last week.
Of course, the nagging question from the ETF/passive revolution remains unanswered. “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”, Howard Marks famously said in 2017. “In this way, appreciation that was driven by passive buying is likely to eventually turn out to be rotational, not perpetual”.
Marks’s fears have yet to be realized, but one thing that’s often forgotten is that on the morning of August 24, 2015, the equity ETF model briefly snapped – where “snapped” is a euphemism for “broke”.
If there is one, single episode that ETF proponents go out of their way to avoid talking about, it’s the events that transpired on that morning.
Just some food for thought.