Lots of financial pundits have encouraged investors to be “passive” investors rather than try to pick stocks, or invest in funds that do that latter (“active” funds). Even the FCA has recently criticised active funds for being more expensive and the additional management fees end up impacting negatively on overall returns over time. So persuasive writers such as John Bogle have convinced many to take the “no brainer” route of buying Exchange Traded Funds (ETFs) or other index tracking funds.
But there are surely dangers creeping up on all of us from this approach evidenced by several interesting articles in the Financial Times and Investors Chronicle in the last week.
On the 7th August John Plender in FTfm showed how index tracking funds break prudent portfolio rules. He warned about the concentration of holdings in Nasdaq stocks where the top five holdings (Apple, Google (Alphabet), Microsoft, Amazon and Facebook) represent 41 per cent of the index. He said “Concentration risk that is forbidden to an active manager is considered reasonable if it happens to be an index. This is dangerous nonsense”.
The Editor of Investors Chronicle published an editorial that warned that one of his worries was the huge inflows to passive funds and said “But I am concerned at the presentation of ETFs as an investment panacea because it has created the impression that investing is easy and riskless”. That is surely very true as private investors have simply bought more and more lately in a steadily rising market in recent years, driven by “momentum” trading styles. They don’t look at the valuations of what they are buying (hey – the index must be the best valuation is it not), they just buy and sell regardless based on trends. As the IC editor also said “What happens when the US bull market comes to an end?”. A good question indeed to which there is an obvious answer – a market crash as investors who have never been through a bear market capitulate.
Just today we have a front page article in the FT headlined “surging flows into exchange traded funds drive US stocks bubble anxiety”. It covers the record breaking in-flows into ETFs this year so far. It includes a good quote from Howard Marks of Oaktree Capital: “When the management of assets is on autopilot, as it is with ETFs, then investment trends can go to great excess”.
I certainly agree that investors need to examine very carefully the costs of the funds they invest in, if they do not wish to invest directly in shares. There may even be a place for index trackers in a portfolio – not that I hold any. But the real worry is that ETFs are now distorting the market and protecting yourself against that distortion, or from the likely collapse when everyone realises the emperor has no clothes, is not easy. It has led to a general rise in asset prices, in particular share prices, while simply staying out of the market while this is going on does not make much sense either.
The situation is surely analogous one of the causes of the great Wall Street crash of 1929 where “trusts” dominated the market and were sold to investors on the basis that they only went up. That was not helped by trusts investing in other trusts in a kind of pyramid scheme, and by low cost finance to purchase shares on margin – and we surely cannot get much lower interest rates than we have now. Restrictions on credit was one immediate cause of the 1929 crash, causing margin calls to be invoked and a spiral down.
There is no simple solution to protect oneself against the hysteria of momentum investing and index tracking, but the most vulnerable shares are undoubtedly those that form a large part of any index. Those are the ones where valuations may become unrealistic and where active traders may not feel it wise to try to sail against the wind. So the message is surely to look askance at unreasonably high valuations in relation to earning or cash flows in companies. Simply “buying the index” when everyone else is doing so is not a sound approach.
Roger Lawson (Twitter: https://twitter.com/RogerWLawson )
In this article: http://www.cityam.com/263818/why-rise-and-rise-passive-funds-should-strengthen-corporate John Redwood tries to argue that passive funds are GOOD for corporate stewardship, because they are forced to hold shares, whereas active investors often simply sell-out, rather than fighting for improved governance. Your recent post: https://www.sharesoc.org/blog/corporate-governance/institutions-cannot-control-pay/ gives the lie to that assertion.
There are two flaws in Redwood’s assertion. 1) It is not borne out by the facts, as we’ve seen from out-of-control remuneration and the rarity of meaningful institutional votes; 2) The assumption that ETF managers care about the performance of the shares than underlie their passive portfolio.
On this second assumption, ETF managers make their % fees irrespective of the performance of their holdings and it seems likely to me that they’d care more about keeping costs down, and hence profits up, by not assuming the considerable cost of proper corporate stewardship, than about performance. This is illustrated by the interview with State Street that you refer to.
Completely agree with you Mark. I think Mr Redwood has been spending too long contemplating his future rather than paying attention to the realities of the investment world.
I concur, partly …
– If 90% of the money is in passive ETFs then the market price will be more volatile, which reduces everyone’s reward-to-risk ratio.
– Some ETFs are also pulling a few fast moves – lending their assets out to others, creating counterparty risk and also underperformance risk (especially if the counterparty is smart).
Areas where I see it a bit differently:
– low cost ETFs and tracker funds are a lot better than traditional managed funds with their high and opaque fees and other costs.
– for a small-scale/youngish/non-analytical/time-poor investor-saver, with a four or five figure portfolio, what they want is somewhere they can get a decent return on their investment, for a limited effort and anxiety, while they are saving for a house deposit or perhaps the early stages of a pension. For them, low cost ETFs and trackers seem better than having direct holdings in companies.