Exchange-traded funds: a crowded trade
ETFs have become a dominant trend, but as with any investing force, there are growing fears of unintended consequences
In late 1999, as the dot-com bubble was starting to take on dangerous proportions, Anna Kournikova appeared in a commercial for brokerage firm Charles Schwab.
As the Russian tennis star stretched courtside and chatted with the umpire, she lectured about the basics of stock investing – valuations, earnings per share, asset allocation. It was but one sign that the stock market had taken on an unprecedented cultural status, at a time when average investors were lulled into thinking they could trade stocks like the pros – an illusion that was shattered when the bubble burst and the ensuing crash wiped out half of the market's value.
Fast-forward almost 20 years, and it's a different legend of tennis aligned with a different investing craze. This past week at a conference for exchange-traded funds in Florida, Serena Williams took the stage for a keynote on the topic of "excellence." Another session featured record producer Quincy Jones talking up a streaming music industry ETF that bears his name. What was once a stuffy trade show for a niche financial product suddenly has the profile to draw A-list celebrities. It's official: ETFs have gone big time.
With nearly $5-trillion (U.S.) in assets globally, growth in ETFs has become a dominant trend of the era, as vast sums of money spurn what's now perceived as the stodgy, outmoded mutual fund in favour of its flashy younger cousin. But as with any investing force that captures the imagination of the masses, there are growing fears of unintended consequences. Just as the frenzy for internet stocks in the late-1990s fuelled the crash that was soon to come, today's fiercest critics suspect that ETFs may be sowing the seeds of a future stock market rout.
There are big, reputable names raising the alarm. From esteemed value investor Seth Klarman, to distressed debt guru Howard Marks, to Nobel Prize-winning economist Robert Shiller, to renowned commodities investor Jim Rogers, they're all warning of potential bubbles arising from ETFs and the style of investing they promote.
"If history is any guide, this will all come to a crashing end," said Ross Healy, a fund manager for nearly 50 years, and chairman of Toronto-based research firm Strategic Analysis Corp. "But when it's working, it's a hell of a lot of fun."
Absent a smoking gun, the main piece of evidence offered up by ETF-phobes is simply how the market has been behaving recently. Almost without fail, the U.S. stock market seems to rise, day after day, with next to no volatility, suggesting the utter absence of concern. The Dow Jones Industrial Average has not declined by 1 per cent or more on a single day since Sept. 5. A hot market tends to fuel itself, luring more and more investors with the promise of runaway profits.
Big ETFs that replicate the performance of the entire stock market, or vast chunks of it, are increasingly the vehicle of choice for new money entering the market. They can be bought and sold on a whim, usually with a few clicks, and they tend to charge a fraction of the fees of mutual funds. As such, they might also be a way for so-called "hot money" to exit quickly when markets get rough.
The enormous SPDR S&P 500 ETF Trust (SPY), for example, is the largest ETF in existence with more than $300-billion in assets. Five years ago, it had $130-billion. Investors in that fund are indeed having a lot of fun riding one of the best stock market runs in history. In the past two years alone, SPY shares have risen in price by 50 per cent.
A growing chorus of market professionals are blaming ETFs for propelling stocks to perilous heights. Passive investing through ETFs – an investing style based on broad stock market exposure – is becoming so popular that it may be distorting the market itself, they say. What if they're right? Could the very thing that democratized investing for the masses and cracked the mutual fund monopoly be inflating a bubble in stocks?
It's far from clear that ETFs and passive investing have yet become big enough to warp the market on any mass scale. But at a certain point, it's certainly possible. ETF detractors raise valid concerns about the unforeseen side effects of a financial innovation causing big changes in how people invest, said Howard Marks, co-founder of Los Angeles-based Oaktree Capital, which manages more than $100-billion. "What if passive investing is changing the operation of the market? Is it still right and good?"
Perhaps the best example of an investing fad becoming a victim of its own popularity was illustrated in devastating fashion by Black Monday – Oct. 19, 1987 – the single-worst trading day in U.S. market history. Much of the blame for that day's selling spree was placed on what had become a common market-hedging strategy called portfolio insurance.
As U.S. stock prices soared through the mid-1980s, institutional investors grew increasingly concerned about a market crash. Those jitters made them quick to embrace a product that could shield them from big losses in the event of a downturn. This was the promise of portfolio insurance – once the market declined by a certain amount it would trigger the automatic selling of stock index futures, which would offset losses in the actual stocks those same investors held.
But an instrument that was designed to protect the individual investor became toxic in widespread use, as initial market declines triggered wave after wave of selling, exacerbating the losses on the day. The Dow Jones industrial average ended the day down by a shocking 23 per cent. "The whole strategy blew up and died that day on the stock exchange floor," said Kim Shannon, president of Toronto-based Sionna Investment Managers, who lived through Black Monday as a rookie trader-analyst.
Passive investing through ETFs also makes a lot of sense at the individual investor level, she said. But an excessive adoption of the style could doom it to the same fate met by portfolio insurance, once the market hits a downturn, if the result is a cascade of selling. "At what point do you have too much of a good thing? No one knows. This is the great experiment," Ms. Shannon said.
The irony is that ETFs were partly conceived as a solution to the havoc wreaked by portfolio insurance on Black Monday. Rattled regulators and exchange operators observed that the automated selling of stock index futures had spread to the underlying stock market, exacerbating the losses in individual share prices. A single instrument representing a basket of stocks that investors could trade, one step removed from the companies listed on the exchange, might provide a useful buffer between the two markets. Thus, the original idea for ETFs was born.
That birth was not treated as a happy occasion by the mutual-fund business. In no mood to relinquish their monopoly, fund companies perceived ETFs as a threat to the established order of things.
The vision for the ETF was essentially to build a mutual fund that could trade throughout the day on a stock exchange, as opposed to the once-daily or once-weekly pricing of mutual funds. This would allow institutional investors to quickly shift money around by trading baskets of stocks. Initially called index participation shares, these instruments were to be introduced on U.S. exchanges in 1989, and were designed to replicate the performance of the S&P 500 index.
The reception was twofold: considerable interest from investors, and immediate resistance from Wall Street incumbents. A lawsuit launched in part by a mutual fund lobby group argued that ETFs were closer to futures contracts than stocks and should be confined to futures exchanges. The legal gambit worked. Stock exchanges were blocked from listing index participation shares.
"ETFs started with a jurisdictional battle," said Eric Kirzner, a finance professor at the University of Toronto's Rotman School of Management. "Right off the bat, there was great opposition."
After the first U.S. ETF prototype was scuppered, the idea migrated to Canada, where the Toronto 35 Index Participation Fund – the predecessor to the iShares S&P/TSX 60 index ETF – was introduced in 1990. Almost 30 years later, ETFs have become a true investing phenomenon, giving average investors options they never had before.
ETFs have opened up access to strategies and asset classes that were once the domain of only the professionals. Today, regular investors can – for better or worse – invest in volatility, commodities, corporate bonds, factors, sectors and leveraged ETFs amplifying the returns of an underlying index. There are marijuana ETFs, blockchain ETFs – even an ETF tracking the U.S. ETF industry ( ETF Industry Exposure & Financial Services ETF, ticker TETF).
Last year, 60 new ETFs launched on the Toronto Stock Exchange, flooding investors with exotic new options. There are now more than 500 ETFs listed in Toronto, and within a couple of years, structured listings including ETFs are on track to crowd out the number of individual stocks trading on the TSX. That's to say nothing of the thousands more available on foreign exchanges.
The examples of specialized ETFs above are tools of "active" investing, which is predicated on the idea that a skilled investor can pick winning sectors and trends to trade on. But the bigger draw of ETFs is in providing plain-vanilla, broad-market index exposure to investors at a fraction of the cost of mutual fund investing.
As awareness surrounding the erosive effect of fees has grown, and as passive investing has performed admirably through the best years of the bull market, ETFs have thrived. Over the last decade, more than $1-trillion has been yanked from U.S. active equity funds and shifted to passive funds (ETFs and mutual funds). Index-investing pioneer Vanguard alone is now taking in about $1-billion in new investor funds every single day, leading its founder, Jack Bogle, to worry that the firm is growing too large.
Passive investing is based on the idea that the market is so hard to beat, it's best not to try. Just build up exposure to the entire stock market, minimize fees and ride the index. The concern now being raised is that if too many investors go that route, there won't be enough active managers left doing the good work of figuring out how much companies are actually worth. "The strength of this country was built on people who watched individual companies," Nobel Prize-winning economist Mr. Shiller recently said on CNBC.
ETFs, in fact, have become Wall Street's favourite scapegoat. They have been called un-American, likened to financial Marxism, accused of inflating asset bubbles, subverting traditional value investing and of pushing the biggest stocks on a relentless upward trajectory with little variation.
One of the ways ETFs might be influencing the market is through fund flows into the biggest stock indexes. The way most national indexes, as with the S&P/TSX composite index, are constructed, means that new ETF money flows to each individual stock in proportion to its market value at the time. Shares of Royal Bank of Canada, for example, being the largest listing on the TSX, would be apportioned the largest chunk of a new investment in a Canadian index ETF. All of the other individual stocks within the index would get successively smaller proportions, going all the way down the list.
That has the effect of locking in one stock's value relative to another, with ETF flows tending to put upward pressure on each component stock in a synchronized way. "You have this side effect where stocks are being pushed around together," said Mark Kamstra, a professor of finance at York University's Schulich School of Business, who specializes in the study of financial bubbles. "It's an interesting set of problems; I don't think they were anticipated." That effect could artificially reduce market volatility, with stocks within an index marching higher in lockstep.
But the power to distort the market requires ETFs being big enough to do so. And ETF devotees usually respond to predictions of doom by saying that neither ETFs nor passive investing in general have yet to assume those kind of proportions. The data seem to back that up, Mr. Kamstra said. He said doesn't yet see evidence of market-level mispricing. After all, most of the market's value is still held outside of managed equity funds. Big chunks of the stock market are held by pension funds, hedge funds, foreign investors and households, for example.
As of late last year, U.S. equity ETFs managed $2.7-trillion in assets. But that amounts to less than 10 per cent of the roughly $30-trillion value of U.S. stock market. Similarly, passive ETFs and mutual funds together accounted for just 12 per cent of the total value of American stocks, according to Bloomberg data.
These are hardly market-warping numbers, according to Daniel Straus, head of ETF research and strategy at National Bank Financial. ETF and passive holdings are even smaller on a global scale, and in the Canadian market, for that matter. "ETFs are transformative in many ways, but relative to other pools of assets, they're still a small piece of the pie," Mr. Straus said. As of 2017 year end, assets in Canadian equity ETFs totalled a little more than $100-billion (Canadian), which is about 5 per cent of the total market capitalization of the Canadian stock market.
Part of the problem is that ETF critics often seem to inflate the market share of ETFs and passive mutual funds. Market-share estimates for passive investment strategies range from 30 per cent to close to 50 per cent of total U.S. equity fund assets, depending on methodology. That has resulted in the mistaken and often-repeated claim that passively managed funds have taken control of half of the U.S. stock market. Again, the U.S. stock market is much bigger than the managed fund business alone.
The real share of the total U.S. stock market in passive funds, according to multiple data sources, is more like 15 per cent. Globally, that figure drops to around 8 per cent, UBS said in a recent report.
More often than not, those most critical of a passive style of investing are also those who are hurt by its popularity, said Yves Rebetez, managing director of Oakville, Ont.-based ETF Insight, specializing in analysis and research.
"A lot of people raising these issues have a clear vested interest in trying to prevent passive from gaining more ground, because it's hurting their business," Mr. Rebetez said. "Those things are hard to stomach for people whose livelihood revolves around being able to pass judgment on securities' prices."
Stock picking in general has a dismal track record in recent years. Among large-cap U.S. equity funds, almost 85 per cent of fund managers failed to beat the S&P 500 after fees over the past 10 years, according to Standard & Poor's SPIVA Scorecard rankings, which show mutual fund performance up to the end of June.
Active managers often complain that the current market environment, where everything moves up relentlessly, has made their jobs impossible. The U.S. market is being led by growth companies such as the tech giants known as the FAANGs – Facebook Inc., Apple Inc., Amazon.com Inc., Netflix Inc., and Google parent Alphabet Inc. – which few value investors would ever touch. That's a tough market for any stock picker to beat. "It's painful, because value stocks have underperformed for years. As a value manager, you slink around and hope nobody corners you," said Strategic Analysis Corp.'s Mr. Healy.
The poor long-term results posted by stock pickers in general have set off an exodus out of active management. In each of the past 10 years, the active-fund space has ceded ground to passive strategies. As with many other frustrated value investors, Mr. Healy said he believes indexing is to blame. And a reckoning is coming for investors who put too much faith in index funds, he said. "One-stop investing doesn't work. It's like you don't have to think about it any more. You may not really understand what you're buying. Eventually, you'll have to suffer the consequences."
Mass redemptions from active funds could quickly reverse, however, if stock pickers start to reliably beat the market. "People chase returns, so if they see active investors doing great, they'll plow back into them," Mr. Kamstra said. Which is why it's odd to hear active managers complain about ETFs skewing valuations, he said. If that's actually happening, who better than a skilled stock picker to take advantage of those mispricings. "If I were an active investor, I'd be loving that stuff. It makes for opportunities," Mr. Kamstra said.
Those opportunities, in theory, could emerge from how ETF money flows to each stock within a fund. Say a smaller, less liquid medical marijuana company is closing in on a big distribution deal. Instead of trying to purchase shares that might not trade that often, an investor might choose to buy a stake in the Horizons Marijuana Life Sciences ETF instead. Enough investors get the same idea and all stocks within the ETF get pushed up on one company's good news.
"Even though nothing might have happened to the other stocks, just because they're part of a bundle, they get bought and sold," Mr. Kamstra said. "That can cause deviations from fundamental value." That's the kind of thing active investing might thrive on.
ETFs could very well grow so large as to be capable of single-handedly dislodging prices from underlying value and inflating a major stock bubble. But the trend has not gone that far yet – not even close, Mr. Rebetez said, despite the enormous sums of investor money that ETFs and passive funds have scooped up in recent years.
Most of that money just represents a shift away from mutual funds, where it would have been allocated in much the same way, but charging considerably higher fees in the process. "People either see the ETF as either the great equalizer, or as a potential weapon of mass destruction," Mr. Rebetez said. "The reality is, it's neither. It's actually just a very elegant investment delivery tool."