ETFs and the greater economy – their impact on financial crises and bubbles bursting

Though banks bear much of the blame for previous financial crises, ordinary investors play a more central role than most people realise…

…through greed, and fear.

Ironically, it is likely to occur through a vehicle which has been created with just that in mind – exchange-traded funds, or ETFs

Listed funds are passive by nature, designed to track the performance of an index of stocks, bonds, currencies or commodities, rather than to pick and choose among individual companies.

The ETFs are very popular;

1. The simplicity and low costs
2. But they could be a time bomb for global markets.
   • Australia – Only listed in Australia in 2009, when it was cheap to buy shares (after the GFC)
3. The popularity of ETFs has soared in the past decade.
   • Passively managed have nearly doubled = 40 per cent of Funds under management (in America)
   • Vanguard alone owns a position greater than 5 per cent in 491 of the stocks on the S&P 500, adding up to nearly 7 per cent of the index’s total market cap.
   • Japan, where the central bank owns big stakes in ETFs, passive investors hold over half of all share market assets.

It’s easy to see why such funds have thrived. ETFs, invested in indices that are theoretically diversified, have consistently outperformed active managers. There are more fund managers than shares because there are a limited number of shares.

Their simplicity is appealing to lay investors, who can focus on broad asset-allocation strategies rather than guessing at individual winners and losers.

Hidden risks

1. ETFs, however, are riskier than many investors appreciate.
2. With cap-weighted indices – funds have no choice but to load up on shares that are already overweight (and often pricey) and neglect those already underweight.
   • As prices rise, investors may become overexposed to a few large shares
   • That’s the opposite of “buy low, sell high.”
3. ASX 300 ETF – $12.5 Bn – One fund is 1% of Aus market cap
4. ASX 300 – Market cap of $1.5 trillion
   • Commonwealth Bank of Australia
   • BHP Billiton
   • Westpac Banking Corp.
   • CSL Ltd.
   • Australia & New Zealand Banking Group Ltd.
   • National Australia Bank Ltd.
   • Wesfarmers Ltd.
   • Woolworths Group Ltd.
   • Macquarie Group Ltd.
   • Rio Tinto
5. The top 10 holdings represent 42.8% of the total ETF.

ETFs can replicate indices in complicated ways.

1. Rather than purchasing all the assets consistent with index weights, some funds use a sub-set, thus exposing investors to tracking error.
2. ETFs must be fully invested and therefore hold minimal cash, which could limit flexibility in a downturn. The rules governing indices can be changed, sometimes arbitrarily.
3. ETFs – by their design and their sheer size – ETFs encourage concentration in a few liquid, large-cap stocks, creating homogenous and momentum-following markets.
4. To have low costs: ETFs to emphasise scale, further exacerbating concentration to the top heavy in the ASX

Risk of bubbles

1. Markets become susceptible to flows from a few, large, passive products.
2. Artificial factors, such as inclusion or exclusion from an index, forces buying and selling; this can lead to misallocations of capital. In the current equity cycle, for instance, over-weighted, liquid, large-cap stocks have benefited disproportionately from forced buying. This increases the risk of bubbles, as in 2000 with the dot-com crash.
3. ETFs may even distort valuations outright.
   • They don’t analyse prices, meaning that they don’t contribute to price discovery.
   • They weaken corporate activism, as passive owners have little interest in corporate governance.
4. ETFs increase volatility and shrink liquidity.
   • Passive funds exhibit significantly higher intraday trades and daily volatility, driven by arbitrage activity between ETFs and the underlying stocks.
   • With ETFs increasingly important as the marginal buyers and sellers of securities, this may increase volatility in periods of instability.

From passive to panic

1. Index funds lock up a large percentage of shares that can only be traded on changes in market capitalisation or other index metrics.
   • Number of shares available to trade may be a lot smaller than investors realise. Especially when dealing with small-cap shares, liquidity will be lower on these assets
2. If a crisis does arise, this is likely to exacerbate the downturn.
   • ETFs will have to sell quickly what they’ve disproportionately bought;
   • Passive indexers may become panic sellers.
     • But they may have trouble finding anyone willing to purchase the holdings they’re trying to liquidate.
   • Example: Imagine that an investor in an ETF with, say, a 10 per cent stake is forced to sell a large part its holding in a single day, such as an industry fund
     • If there are no ready buyers for such a large holding, causing the ETF to fall to a price below the value of the assets it owns.
     • This price impact may be exaggerated, as ETF activity intensifies both upswings and downswings.
     • Crashes, when they happen, may be bigger.

Take advantage

1. How resilient you will be when conditions change.
2. Untested structures have revealed hidden weaknesses which have threatened wealth and financial stability. There’s no reason to think next time will be any different.
3. But: You can buy ETFs when they crash
   • If they crash, they will crash harder then most active managed funds

Summary

1. Indexes are great, but not without risk
2. Get some index, but make sure it is diversified
3. Look at smaller caps, but LICs not ETFs in small cap

Thanks for listening!