What if everyone buys ETFs?

The most common investment advice that I have heard for the past year is: Buy ETFs. Almost everyone I know who is a little savvy about investments is advocating for ETFs, specifically Index ETFs. Best of all this investment strategy is so easy to execute that almost everyone, regardless of his or her level of sophistication in investing can do it. It is this moment, my inner realist whispers to me. If this is so good and so easy to execute and everyone knows it, … then it is too good to be true. This post won’t discuss in detail about the merits of ETFs, as there are hundreds of articles that does that in more detail. Instead, this post plays the anti hero; and asks the question…

“What happens if everyone buys ETFs? If everyone is tracking the market, who is making the market?”

Personal note: This post is not trying to discourage people from buying ETFs. It is also not trying to encourage people to support the market ecosystem by becoming active investors. Most of us are retail investors whose single minuscule power doesn’t move the needle. This post wants to highlight the discussions that have been happening at the macro level. So that, retail investors like us is aware of the trend, its possible implications and decide what we want to do for ourselves.

Active management vs Passive management

Before we take a look at why ETFs is becoming so popular, let’s recap on the two investment approaches. An investor who actively manages his stock investment looks out for mis-priced or undervalued stock; and buys it hoping that he can profit from the correction by the market of the mis-pricing of the stock. A passive investors looks to minimize the tracking errors between his portfolio and the market; thus the performance of his portfolio mimics the performance of the market. A passive investor likely also believe that index funds that tracks the markets will outperforms actively managed portfolios in the long run.

ETF is a passive investment vehicle. It has been strongly advocated in the space of personal finance. The first ETFs were conceived in the early 1990s. The Toronto Index Participation Shares was the first ‘ETF’ that managed to successfully start trading; on the Toronto Stock Exchange (TSE). In 1993, the Standard & Poor’s Depository Receipts (SPDRs), commonly known as ‘Spiders’ was developed by Nathan Most, Stevem Bloom and Ivers Riley. Today SPDR has become one of the largest ETFs in the world. The 2 funds tracks the TSE 100 Index and S&P 500 Index respectively.

Why is ETFs becoming so popular?

In 2016, passive funds in U.S. attracted $506 billion and actively managed funds posted $341 billions in withdrawal, according to Morningstar. The biggest argument for ETFs is that the stock market will outperform other actively managed investments in the long term. Even the Oracle of Omaha, Warren Buffett, puts his money behind it by making a $1 million wager in 2007; betting that the Vanguard S&P 500 Index Fund will outperform actively managed hedge funds over 10 years when all the expenses and fees are included. That wager ended in 2017. Vanguard S&P 500 index fund averaged an annualized gain of 8.5%, while Protégé Partners’ five funds averaged an annual gain of 3%.

MoneyBullandThinkingBear - ETF

From www.valuewalk.com

ETFs can be traded intraday like a stock and have a low management fee. Most ETFs do not have sales charges and have low annual fee; there are some index ETFs that charge as low as $3 for every $10,000 managed. Conversely, actively hedge funds usually generate taxable capital gains or dividend distributions that must be passed on to shareholders every year. Some ETFs have a tax efficient hybrid structure that reduces the tax liabilities of its shareholders.

The increase in popularity of ETF was also due to the increase in awareness by retail investors and recommendation by financial advisors to their clients.

moneybullandthinkingbear - ETF 2

What is the risks if everyone buys ETFs?

The below presumptions made in anticipation of what will happen if the current trend persists and investors all heads towards ETFs. This has not been any has not happened before. If you have read similar articles, it is important to note if the views are coming from hedge funds managers, ETFs fund managers or ‘neutral’ parties.

If everyone is tracking the index, nobody is watching the market

The first concern is that passive investment feels like ‘auto pilot’, where the course of the plane is not determined based on factors that drives the demand and supply of the stock price, potential growth, management performances, and economics factors. Passive investors piggy back on the investment decisions of active investors. Passive investment alone do not have a strong basis for allocation of capital. As ETFs become more and more popular, there are people who believes that once the number of passive investors exceeds the number of active investors by a certain ‘threshold’, the markets will start to behave differently from the markets we have known from the past till now. This is because when there are fewer investors studying the stocks and doing actual price discovery.

In 2016, Sanford C. Bernstein & Co LLC, described passive investing as promoting a system of capital allocation worse than both capitalism and Marxism. Note: Sanford C. Bernstein & Co LLC seems to be an active investment management company.

With fewer active investors…

Having fewer number of active investors – who study and keep an eye on the stocks on individual companies – is distorting the ability of the market to set the appropriate prices for stocks and bonds. Market efficiency depends on investors pricing stocks according to their perceived profitability, and ETFs do not engage in this so-called price discovery. The buy and selling from ETFs adds to the volume and also distort the signals in the stock markets. They would buy the shares of the companies that forms the largest market cap. This makes the most valuable companies more valuable and their prices will continue to rise. Market will need to depend on active investors to counteract the upward price movement effectively in order to reflect the price correctly. The fewer active investors, the harder it would be to counter the price movements.

How close are we to that ‘threshold’?

Nobody is able to conclusively say that is this ‘threshold’. I doubt anyone is willing to put a number to the ‘threshold’. It is bold to claim that you can conclusively determine which straw will break the camel’s back. Currently. what is the percentage of stocks owned by index funds? An estimate by BlackRock Inc. (on 4 Oct 2017) reported that 17.5% of the global stock market is managed by index funds/ investors. The percentage points suggests that passive investing is limited in the loss it is causing to price discovery. A more complete breakdown shows

  • Global Equity Market Capitalization = $67.9 trillion
  • Passively Managed Mutual Funds/ ETFs/ Index Investors = $11.9 trillion (17.5%)
  • Actively Managed Hedge Funds/ Mutual Funds/ Investors = $17.4 trillion (25.6%)
  • Government/ Pension Funds/ Insurers/ Other investors not overseen by asset manager or tracks an index= $38.6 trillion (56.9%)

However, it is not clear from the publication that third group (i.e. government, pension funds and other insurers) is not tracking the index. A portion of these group of investors could be closet ‘passive’ investors; retail and institutional investors who have not declare that they are pursing indexing strategies. We should also note that BlackRock is one of the world’s largest manager of ETFs, together with State Street and Vanguard Group. I’d take the interpretation of the message with a pinch of salt and guess the actual percentage of passive investors to be more than 17.5%.

Separately..

According to Moody’s (on 2 Feb 2017), passive funds account for 29% of the U.S. market. They claim that the main reason causing funds to flow from active funds into passive funds is because investors are gaining awareness that actively managed investments, in general, cannot deliver above average performance. Moody’s Investor Service also anticipates that by 2024; more than half of the assets in investment management business would be Index Funds.

Personally, I find comfort in knowing that there is still $11.9 trillion being actively managed. That is still a lot of money at stake, to make sure price discovery is done properly.

There may not be enough liquidity

Another concern is that liquidity of ETFs have not been fully tested in a big bearish market yet. They may not be able to protect investors during heavy market sell offs. The analogy is that during a big fire; whether everyone is able to get out of the room in time and safely would depend on how many doors are there and how big they are. The rooms in this case refers to the ETFs. In a heavy bearish market sell off, a bout of withdrawal of funds from ETFs will add to the downward pressure on the prices of the stocks in the index ETF basket. ETF fund managers would also have difficulty in re-balancing the stocks in their portfolio, as there is a lower demand for these stocks.

The way I see it in a heavy bearish market, there will not be enough demand for all stocks across the market for the price to be supported. Some investors would be caught wrong footed. If there is a heavy bearish market sell off, this would not be a problem only for ETF fund managers. This would be a problem for all investors. Retail investors would not be able to withdraw their funds from the ETFs before the price drops. Even actively managed accounts would have difficulty selling their stocks due to the lower demand. The concern about the liquidity of ETFs could be valid, but I am not sure if this concern can ever be verified during a bearish market sell off.

My thoughts as an individual..

… about everyone buying ETFs

If we explore the extremely unlikely scenario, where 100% of the global equity market capitalization is owned by passive investors who tracks the market, there will be nobody speculating on individual stocks to create any market movement. Without market movement, there will be no pulse and global equity market would literally “flat lined”. And when this happens, there would be many stock that will be mis-priced. People will chase after these mis-priced stock to profit from the correct of the mis-pricing. Funds would flow into active management.

As more and more money flow into active management, it might be possible that there is too much money chasing this mis-pricing and most people do not become profitable. Then funds will flow back into passive management and the active managed industry will begin to shrink. So the flow of money between active and passive management, could be cyclical. With passive management at 20% to 30%, the scenario where there is ‘too much’ funds in passive management is still a few years away. It would be good to equip ourselves with the skills to identify mis-priced stocks now.

… about myself buying ETFs

William Sharpe, an Economics Nobel Prize winner, published an article in the 1991 edition of Financial Analysts Journal: “The Arithmetic of Active Management.” He pointed out that the entire market equals to the combined portfolios of all active and passive managers. He argues that because index funds own each stock in a similar proportion as the market capitalization of the stock in the stock market. Subtracting those index funds, and the remaining actively managed portion must collectively equal to the market as well.

Consequently, if active managers hold portfolio of stocks that are different in composition from the market, there would be some portfolio managers who would hold stocks that outperforms the market, and others who would hold the remaining stocks that under-perform the market. According to a Morningstar report in Aug 2018, only 36% of active managers in the US outperforms their passive investing peers. This is based on the 12 months period from June 2017 till June 2018.

If the ability to pick stocks that would outperform the market is an outcome of deep understanding of finance and economics, comprehensive due diligence of companies and some astute market sense. Those of us who doesn’t yet possess such savvy-ness, we might be better of buying ETFs that tracks the market performance.

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