ETFs are not WMDs

RYAN  By Guest Blogger Ryan Lewenza

A recently published report on ETFs has been making the rounds with its doomsday prediction that “ETFs are ‘weapons of mass destruction’ that have distorted stock prices and created the potential for a market selloff.” With us being strong supporters of ETFs and only use them when building client portfolios, we felt it was prudent to address this bogus claim.

In the report by a US-based portfolio manager their basic premise is that by investing in index based ETFs, investors are no longer doing fundamental analysis which is pushing up equity valuations, creating market inefficiencies and the potential for a major market decline. We disagree and here’s why:

1. Size of the ETF market
The ETF market has exploded in recent years with more investors turning to them and more players coming into the marketplace with new and innovative structures. Next week my partner Doug Rowat will discuss the downside of some ETFs (there are now ETFs with 4x leverage which are about as dangerous as President Trump with a termination letter).

Despite this explosion in popularity, ETFs still represent a small fraction of the overall market. Looking at the US markets there is currently US$16.3 trillion in mutual funds and only US$2.5 trillion in ETFs, according to the Investment Company Institute. Yes, ETFs as a percentage of total US investments has risen sharply from less than 1% in 2000 to 13% currently, but still it represents a small percentage of the overall amount. Therefore I think their impact on the overall market is being overstated.

Total US Mutual Funds and ETFs

Source: Investment Company Institute, Turner Investments

2. They own the same stocks
The key complaint about ETFs is that as new money flows into ETFs, they indiscriminately buy all stocks or bonds in the index, regardless of fundamentals. But all too often the active portfolio managers just end up buying the same stocks that are in the index, which in the biz we call “closet indexers”. These portfolio managers tend to be more worried about managing their careers (so they stay close to their benchmark index) than taking risks and making informed bets based on their market research.

Secondly, this belief assumes that portfolio managers can actually pick better stocks through their fundamental research and outperform the benchmark. But this is just not the case when looking at all active portfolio managers. For example, Standard & Poor’s recently analyzed actively managed portfolio managers around the globe and found that 98.9% of active US equity funds underperformed their benchmarks over the last 10 years.

So what’s the benefit of investing your money with active portfolio managers, who complete this fundamental analysis, and charge 2-3% fees, if they can’t beat the market?

3. Index investing is not new
Index funds are mutual funds that track an index, and have been around for decades. Index funds date back to the early 1970s with the introduction of the first index fund which tracked the Dow Jones Industrial Average. So this type of investing is not new and we haven’t seen index funds having a larger impact on the markets than traditional active mutual funds over this period. Selling is selling. What does it matter if it’s in an index-based ETF or an active mutual fund? Admittedly, you could make the argument that it’s easier to sell an ETF than a mutual fund given that it trades daily on an exchange, but if investors want to sell and reduce their equity exposure, I don’t believe owning an active mutual fund versus an ETF would cause investors to hold the investment longer and ride out the anticipated downturn.

Interestingly, there were also naysayers back then saying the same thing about the proliferation of index funds as they are saying now about ETFs. Below is a great quote from an analyst in 1975 claiming that index funds would lead to an inefficient market and with inflows driving stock prices with no fundamental consideration. Sound familiar?

Concerns of Index Funds Existed in 1975

Source: Bloomberg

4. Active managers justifying their poor performance
Finally, a lot of these protestations over ETFs sounds like sour grapes to me. Many investors and professional money managers have questioned this bull market and held large cash balances. This has led to significant underperformance and disappointing returns.

Case in point, the authors of the ETF report run a large equity mutual fund that has returned 4.3% annually over the last 10 years versus its benchmark at 7.7%, and 3.7% annually over the last 5 years versus their benchmark at 12.7%. Their weaker performance was in part due to their defensive positioning and high cash balance. Now it appears to me that instead of owning their decision to hold high cash balances and the weaker performance that resulted because of it, they are now blaming ETFs because, in their view, they are negatively impacting market dynamics.

I’ve been in this business a long time and have always tried to avoid taking shots at analysts and portfolio managers since I understand just how hard successful investing is. But that said, I’m not buying their argument that ETFs are leading to market inefficiencies and will cause a major market sell off. Maybe these portfolio managers should work a bit harder, uncover some value in the US equity markets, put that high cash balance to work and stop bemoaning the growth of the ETF space.

Ryan Lewenza, CFA,CMT is a Partner and Portfolio Manager with Turner Investments, and a Senior Vice President, Private Client Group, of Raymond James Ltd.