.png)
(Boom Bubble Bust: Part II - The ETF Mania)
In a detailed note from Howard Marks, CFA (co-chairman of Oaktree Capital Management [external link]) we picked out some of his thoughts on exchange traded funds (ETFs). We would certainly recommend reading his note – There They Go Again…Again – in full. It can be found here [external link].
The growth of investor interest in tracker funds has been staggering. As well as lack of confidence in actively managed strategies, this came about because many are confused by markets and what is driving them. But if you get confused when you are driving is it sensible to take your hands off the wheel and hope the car goes in the right direction? Surely when markets are confused or confusing this is time to engage brain more, not less?
Howard Marks emphasises the challenges investors face:
“Like all investment fashions, passive investing is being warmly embraced for its positives:
- Passive portfolios have outperformed active investing over the last decade or so.
- With passive investing you’re guaranteed not to underperform the index.
- Finally, the much lower fees and expenses on passive vehicles are certain to constitute a permanent advantage relative to active management.
Does that mean passive investing, index funds and ETFs are a no-lose proposition? Certainly not:
- While passive investors protect against the risk of underperforming, they also surrender the possibility of outperforming.
- The recent underperformance on the part of active investors may well prove to be cyclical rather than permanent.
- As a product of the last several years, ETFs’ promise of liquidity has yet to be tested in a major bear market, particularly in less-liquid fields like high yield bonds.”
Engaging brain
“Passive investing” is a contradiction in terms. “Investing” requires analytical work to uncover investment opportunities. Passive strategies ignore this. Floods of money into passive strategies have the effect of pumping up the share prices of index constituents whatever their quality, making markets less, not more, efficient.
Howard Marks again:
“Remember, the wisdom of passive investing stems from the belief that the efforts of active investors cause assets to be fairly priced – that’s why there are no bargains to find. But what happens when the majority of equity investment comes to be managed passively?”
In a world where passive funds dominate and there are no active managers doing the leg work to uncover bargains, how do you know what is a “fair” price for a stock? If passive funds allocate investors’ money merely based on the size of companies in an index, where is the thought in that process? Is successful investing so easy that you can completely dis-engage brain?
Achieving scale
Passive managers have expanded their range to different “styles”, for instance “low volatility” or value stocks. This creates another strange situation, as Howard explains:
“The low fees and expenses that make passive investments attractive mean their organizers have to emphasize scale. To earn higher fees than index funds and achieve profitable scale, ETF sponsors have been turning to “smarter,” not-exactly-passive vehicles. Thus, ETFs have been organized to meet (or create) demand for funds in specialized areas such as various stock categories (value or growth), stock characteristics (low volatility or high quality), types of companies, or geographies. There are passive ETFs for people who want growth, value, high quality, low volatility and momentum. Going to the extreme, investors now can choose from funds that invest passively in companies that have gender-diverse senior management, practice “biblically responsible investing,” or focus on medical marijuana, solutions to obesity, serving millennials, and whiskey and spirits.
…Importantly, organizers wanting their “smart” products to reach commercial scale are likely to rely heavily on the largest-capitalization, most-liquid stocks. For example, having Apple in your ETF allows it to get really big. Thus, Apple is included today in ETFs emphasizing tech, growth, value, momentum, large-caps, high quality, low volatility, dividends, and leverage.”
A sensible innovation
We have made the point before that ETFs are a useful innovation. But that innovation has become a passive-aggressive mania (more here). This creates strange contradictions, as Howard Marks and ourselves have pointed out.
Be very wary.
FURTHER READING