Clients sometimes ask me what my biggest worry about the market is, the “What keeps you up at night?” question. Long time readers of my investment letters will immediately assume that my answer would be “everything”, and that might be fair, but at the moment I think our biggest worry here at Radnor is the concurrent rise of ETF’s and the march towards market dominance of Index investing.
Here’s a thought exercise:
You are in the market for a house. The realtor with whom you are working steers you to a particular neighborhood, with a diverse stock of houses, in an effort to give you some perspective on the local market. You see shacks, McMansions, and actual mansions- in pristine condition all the way to severe neglect, and with lot sizes varying from a quarter acre to 20 acres. When you’ve had a chance to drive up and down a bit, you start to inquire about prices. You point to a medium-sized house for sale, and he gives you a price. You point to a much larger one, and he gives you a price; in fact, the same price. You point to a shotgun shack, and that’s the same price too. In fact, every house in the neighborhood has the same price, take it or leave it. There is no chance for submitting a bid based on house size or lot size or location or view or relative level of upkeep or improvements, and then negotiating to a final deal- what in stock terms might be referred to as “price discovery”- because every house is the same price, regardless of the differences. It might run through your mind, once you’ve digested this news, that maybe you don’t want to pay the same price for the shack as you would for the palatial mansion, but the realtor assures you that it really doesn’t matter, because that neighborhood, and its uniform price, has been appreciating nicely for years. Would that make any logical sense to you? It doesn’t to us, and yet that’s the same suspension of logic in which one engages when buying an Index Fund. We would assert that it will matter if you pay mansion prices for the shack, but similar risk is being ignored by the money which has continued to pour into Equity Index ETF’s, mostly Indexed:
…and with most of those funds going into passive products, at the expense of active. Per a recent piece by CNBC:
“Flows out of actively managed U.S. equity mutual funds leaped to $264.5 billion in 2016, while flows into passive index funds and ETFs were $236.1 billion, according to data provided by the Vanguard Group and Morningstar. That was the greatest calendar-year asset change in the last decade, during which more than $1 trillion has shifted from active to passive U.S. equity funds.”
Merrill Lynch predicts that, at current run rates, indexed equity assets could exceed actively managed assets in as little as 6 or 7 years. Generally speaking, however, when a trend accelerates to the point where you can make an extreme statement like that, it’s probably not going to happen.
At any rate, there are many reasons cited for why Funds have continued flowing into Index Funds and ETF’s, including the following:
- Passive is better than active, in that in any given year, at least 75% of active managers on average cannot beat the Index; if you can’t beat ‘em, join ‘em.
- As the marketing materials say, “Indexing is a good way to avoid single stock risk”.
- ETF’s and Indexes are an easy and inexpensive way to diversify among different styles and capitalizations.
- ETF’s, Index or otherwise, are “safe” and liquid investing options
So, let’s look at some of these statements/ rationales.
For starters, what is “Passive”? As we have said before, if “passive” means “no trading”, then in fact the Index portfolios themselves only change when the underlying Index is rebalanced; low to no turnover. However, the ETF’s themselves can and are traded very frequently, and in fact, traditional active stock trading has just morphed into active ETF trading.
As a recent piece from Bloomberg put it:
“ETF’s have gathered more than $2.7 Trillion in assets today, of which around $400 Billion is held in the three biggest S&P 500 ETF’s (one of which is Vanguard’s)… in March $484 Billion worth of these ETF’s changed hands, a turnover of 121 percent in one month… This is not the action of buy and hold investors”.
This is not by any means only Mom and Pop investors either, we might add, with the trading volume indicating significant institutional ownership/activity, not least by Hedge Funds whose ETF ownership of has grown about 77% the last year, per a recent Deutsche Bank report. Deutsche Bank further indicates that, “data suggest that Hedge Funds use ETF’s for gaining quick and efficient asset class access across the long and the short side, similar to futures contacts”. As the ETF use is predominantly S&P Index products, it does seem somewhat ironic that a “passive investing vehicle” is used for such active trading. At any rate, when the market dips, money pours out of “passive” index funds, only to pour back in again once the market is climbing again (see: the post-election Trump Rally).
For additional perspective on this, consider that, per a recent Morningstar analysis, the SPDR S&P 500 ETF, one of the largest market-traded Index products with $204 Billion in assets, has an average holding period of 15.4 days; that ain’t your basic “Buy and Hold”.
Meanwhile, back to Mom and Pop, investors who have been streaming into Indexes have been content to be passive because the ride for the last 6 or 7 years has been agreeably, and fairly linearly, upwards, ergo “safe”. Will that money stay ”passive” when and as the underlying Index heads South for a protracted period?
From a recent Grant’s Interest Rate Observer:
“…we think that the psychology of all of the capital that has gone into the ETFs might be quicker to pull the trigger to sell than if they had 50 different stocks that they had owned for years. I think a retail investor who has got capital in an ETF is more likely, just because it is a lot easier, to just sell the ETF if the market starts heading the other way”.
Human nature (herd instinct) and loss aversion being what they are, at some point passive holders of these investments could easily turn into active sellers, something that, given the dollar values involved, could easily turn into a panic, with as little “price discovery” on the way out as on the way in.
With regard to diversification, a closer look at the individual constituents of the S&P and their returns quickly debunks this myth. Consider that when you purchase an index fund or ETF to the S&P 500 today, more than 12% of your dollars will be invested into just five companies- Apple, Amazon, Netflix, Google/Alphabet and Facebook because these five stocks represent 12.4% of the total market capitalization of S&P 500 and, although they represent only 1% of the total number of companies in the index, they accounted for 37% of the S&P 500’s total return this year through April 27th and 45% of the Nasdaq’s recent march to 6000.
It might also be noted that a slightly different five names- minus Netflix and plus Microsoft, now account for a full 10% of the entire U.S. stock market capitalization. By extension, this means that virtually all U.S. Large Cap Equity Index products- ETF, Mutual Fund, or otherwise- will have more or less 10% of their assets in these 5 names. And, since the S&P Index and most others are capitalization weighted, this means that as investor funds push into Index vehicles, these big names get even bigger, thus increasing the concentration risk. With all due respect to the Index ETF marketers, this creates fairly high leverage to a small group of individual stocks, many of which are quite overvalued by any traditional historical standard.
In the short run, we are losing out by not being up to our eyeballs in Amazon et al. But we think it will help to mitigate the pain when/as things turn. Yes, indiscriminate selling of S&P 500 Index products will mean that all 500 names get hit, proportional to their Index weighting, and that means pretty much all Large Cap stocks we own for clients are going to be vulnerable. However, to the extent we are not particularly leveraged to the biggest (and in many cases most overvalued; certainly over-owned) names, we will hopefully be in the “less worse” category, come the next major market decline.
As to diversification, it used to be that investment styles (Growth, Value) and market capitalization ranges (Small, Mid, Large Cap) went in and out of favor. This is still the case, but considerably less so, given the lack of price and valuation discernment on the part of Index investors, and ETF investing more generally. The fact that so many of the same names show up in so many ETF’s (Apple is in 240 ETF’s as of 3/31/17, and not surprisingly, given its Index weighting, represents at least a “top 15” position in 135 of them) has led to a much higher degree of homogeneity in market returns. Using ETF’s for the 5 years ending 12/31/16, the iShares core S&P 500 ETF was up 14.55%. The iShares S&P 500 value ETF was up 14.48%. The iShares S&P 500 Growth ETF was up 14.33% and for that matter, the iShares Russell 2000 (Small Cap) ETF was up 14.95%, (with similar bunching around its Value and Growth subsets), notwithstanding the fact that a full 28% of that Index is represented by companies that have no earnings.
“Central Tendency” in the extreme.
Finally, as to Liquidity, that part remains unproven. Assets in Equity ETF’s are now about 3 ½ the times levels which obtained at the end of the Great Financial Crisis, and there is about $1.5 Trillion in passive (Index) investment vehicles that wasn’t there in 2009. None of that has been stress tested in a particularly negative market environment, but what we have seen episodically in the last couple of years is not encouraging.
To anticipate the reasonable rejoinder to all of this, yes, we are traditional stock picking “active” managers here at Radnor, part of a subset of the investment business with some participants who view the surge of Indexing as some sort of existential threat. Why wouldn’t we be at least a little defensive about it, and be looking to poke holes? On the other hand, Jack Bogle established the first Index Fund at Vanguard in 1975, so they have been a reality, and an investment option, for investors for pretty much the entirety of our careers. Index funds per se are not the problem. Rather, it’s the ETF- enabled and asset allocation model- driven surge into index products, in a period when everything has been going right (including, not least, the most benign Fed interest rate policy in history) that concerns us, along with their burgeoning use as a quite active trading vehicle. In the short run, our pointing out the high valuations of some of the names currently providing Index leadership might properly be answered with “Who cares? It’s working!”. However, that doesn’t strike us as a particularly effective long term investment strategy, and our worries center on what happens when investors are forced to “care” again; in the long run, valuation does matter, and we choose, on behalf of our clients, to continue to be guided by it.
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- Some information in this presentation is gleaned from third party sources, and while believed to be reliable, is not independently verified. Any charts, graphs, or visual aids presented herein are intended to demonstrate concepts more fully discussed in the text of this brochure, and which cannot be fully explained without the assistance of a professional from Radnor Capital Management, LLC. Readers should not in any way interpret these visual aids as a device with which to ascertain investment decisions or an investment approach. Only your professional adviser should interpret this information.
- The S&P 500 is an unmanaged index used as a general measure of market performance. You cannot invest directly in an index, and therefore performance of these indices cannot be shown net of fees or expenses. These fees would, if imposed, have a materially adverse effect on performance.
:Lewis Braham, CNBC, 4/17/17 –http://www.cnbc.com/2017/04/17/a-seismic-shift-is-happening-and-billions-are-pouring-into-these-funds.html
 :Joe Nocera, Bloomberg, 4/25/17-https://www.bloomberg.com/view/articles/2017-04-25/index-funds-are-finally-sexy-what-a-shame
 : From “The 2016 Guide to Institutional ETF Ownership”, Deutsche Bank, 4/11/17, as quoted on Zero Hedge, 4/12/17
 :As quoted in A Wealth of Common Sense Blog, 5/7/17;( http://awealthofcommonsense.com/2017/05/passive-aggressive-investing/)
 :Grant’s Interest Rate Observer, Vol.35, No. 09, 5/15/17
 :Goldman Sachs analysis, as reported by Zero Hedge, 4/28/17; http://www.zerohedge.com/news/2017-04-28/just-these-five-companies-account-28-sps-2017-returns
 :From the Stahl Report Compendium, April 2017