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Should Investors Fear the Rise of the ETF?

October 28, 2016

 

The Exchange Traded Fund,  unsurprisingly has seen its name simplified by Wall Street to its more common abbreviated title as the ETF. So what is an ETF and why has it attracted over a trillion dollars in investor’s capital? An ETF is a financial instrument in which its sole purpose is to track the performance of an underlying benchmark. Such benchmarks may be a stock index, asset class, geographical region or investment strategy. An ETF is not designed to outperform the benchmark but rather replicate its performance as close as possible. Similar to a common stock, the price of an ETF fluctuates and can be traded throughout the day on an exchange.

 

So why has this financial instrument gained so much popularity in the recent years? We’ve identified a few themes which we believe are driving this. First, the general public has adopted a cost conscious approach to investing, with the ETF acting as a cheap alternative to expensive mutual funds which rarely beat the underlying index. Second, the implied simplicity and convenience offered by the ETF allows investors to adopt a “do it yourself” strategy. Third, with 2015 as an exception, the broader market has performed very well over the past few years and their mirrored ETFs have obviously followed suit. It is not a coincidence that these three themes came about after the recent financial crisis.

 

At this point in the article, the ETF probably looks to be an attractive alternative investment option for the general public. After all, how can one argue otherwise given its obvious popularity? With that said, this article is not trying to counter the benefits that the ETF can provide, but rather highlight a few of our concerns that may arise given the significant and relatively sudden inflow of investor’s capital into these products.

 

Let’s take a deeper look using a traditional index based ETF as an example, whereby each unit of an index ETF is backed by a basket of shares which mirror the same proportional weight as its index’s constituents. This means that as ETF units are created or redeemed, ETF dealers must transact by buying or selling those underlying securities within the index. If such transactions originate from non-fundamental based trading, the underlying securities can experience increased price volatility and provide stock prices that have nothing to do with an actual company’s fundamentals. For example, as more investors feel optimistic about the market and funds flowing into the ETF rises, the greater the artificial inflation of its constituents. Similarly, when investors feel negative about the market and sell their ETF, many of its constituents drop to values way below what the fundamentals would justify. This is concerning as when the overall index fails to reflect the value of the underlying securities, a period of large negative returns could result.

 

To understand the magnitude of the capital flowing into ETFs, consider that a large proportion of ETF participants are small retail investors. These are the individuals attracted by the lower costs and “do it yourself” strategy. Although one would hope that these retail investors are performing their own due diligence, the reality is that most are not and simply opt to allocate a portion of their savings into a popular ETF. This means that little, if any, thought is given to the actual underlying valuation of the index’s constituents. This undermines the true foundation of investing – that is, owning a piece of a strong underlying business. Not buying everything the market has to offer and hoping there are enough good companies in the basket to offset the bad ones. Unfortunately, the popularity of such a simplistic investment approach is enormous and has fueled unprecedented funds flow into ETFs, which artificially influences valuations of the constituents.

 

Additionally, retail investors have the tendency to fall victim to many emotional biases and who’s to blame them for doing so? It is only human nature to become unnerved as the value of your hard earned invested savings fluctuates daily. Falling victim to these biases in combination with the perceived lower ETF fees draws retail investors into pursuing a more active trading style, such as following the hottest trend. When considering the increased price volatility and higher cumulative transaction costs that come with more frequent trading, the ETF may not end up being as cheap as made out to be.

 

ETFs can also create a synthetic correlation amongst its basket of securities. As an example, Wal-Mart recently reported lower earnings guidance and as can be expected, its share price declined. Since much of the lower guidance was a consequence of Wal-Mart specific issues, such as higher labour costs, it would be expected that only its share price should be affected. However, immediately following the announcement, companies within the similar industry, such as Costco, also saw its stock price decline. This was the case as investors sold their consumer staples sector ETF, which ultimately puts selling pressure on its whole basket of stocks. This is just one example of how ETF trading can trigger contagion within the market.

 

Furthermore, the number of ETFs offered has significantly increased over the years, from 100 in 2003 to over 1,000 today. It is tough to conclude that the rise in ETF offerings was centered solely on the interest of the consumer. It seems more realistic that the fund management companies adopted a “throw at the wall and see what sticks” strategy and why not, as they collected fees for doing so. After all, can you decipher what the Global X Guru Index ETF means? As the variety of ETFs offered increased, so did their complexity. This led to the creation of supercharged ETFs where the complexities of these instruments are not fully understood by the individuals that purchase them. This is neither good nor sustainable.

 

To conclude, we do not disagree with the benefits ETFs can offer but rather advise caution going forward. After all, ETFs have experienced an unprecedented influx of capital with their long-term implications yet to be seen. The popularity of ETFs has driven many ETFs to become the top shareholder of some of the largest public companies. Additionally, ETF based trading is estimated to account for 25% of daily trading volume. These astonishing statistics truly emphasize how ETFs have become ingrained within our financial system and therefore their long-term implications to all investors warrant a greater understanding.

 

The Summerhill Team

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