ETFs and Market Fragility

In case you haven’t noticed, capital has been flooding out of active investing (where managers buy stocks and build their own portfolio) and into passive vehicles such as Exchange Traded Funds (ETFs).

The U.S. ETF market now has about $2.7 trillion in assets. The majority of this money is in products that track indexes. ETFs have attracted more than $160 billion in new flows so far this year, Bloomberg says.

Why should you care? Let’s suppose you invest in an S&P 500 index ETF. The index is market weighted. As funds flow into the ETF, they are invested in the largest stocks which then become even larger. The index is increasingly skewed by investment flows, becoming less and less representative of the actual performance of the 500 companies that compose the index. The ETF is increasingly dependent on the performance of a few stocks.

Did you know that five of the S&P 500…1%…accounted for 28% of the performance of the index last year? Is this what you would call being diversified? The index no longer reflects the performance of the underlying stocks; it reflects money flows and results in a misallocation of capital away from smaller companies. Will this distort price discovery for the individual stocks? I think so. What happens when the market heads down and the index ETFs have to sell the big stocks disproportionately?

Or consider an ETF for emerging market debt. You want diversification but what do you get? You get a very unbalanced portfolio of U.S. dollar denominated debt that is liquid enough to be traded. But not many people check under the hood to see what the ETF actually holds.

Arik Ahitov and Dennis Bryan run the $789 million FPA Capital fund. They write that “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.”

The flood of money into passive products is making stock prices move in lockstep, creating markets increasingly divorced from underlying fundamentals, they say. As the market moves ever higher, there’s greater potential for a sharp decline. “This new market structure hasn’t been tested,” they claim, noting that the stock market has never gone through a major downturn when passive investors were as important as they are now. “We could get an onslaught of selling.”

Eric Peters, CIO of One River Asset Management, made a similarly stark warning in an email to clients: “There is no such thing as price discovery in index investing. And there will be no price discovery on the downside either. The stocks that have been blindly bought on the way up will be blindly sold. When these markets do finally have a correction there will be no bid for many of these stocks.”

The proliferation of index funds clearly increases price distortions as the companies included in the index and their weightings change. Companies leaving the index are smashed indiscriminately while others suddenly soar due entirely to entering the index. These moves are especially exaggerated in junior stocks ETFs where the underlying stocks may have very little liquidity. Major brokerage houses now have entire departments dedicated to guessing these reallocations while average investors are left wondering what happened.

Just another reason to go to cash these days dear reader.