InnOvation Capital & Management, LLC
IntelDigest
LAW – POLICY – FINANCE – MARKETS
INFORMATION FOR THE ENTERPRISE AND INVESTOR
AUGUST 16 , 2017
Contact Richard Power with comments or questions. IntelDigest is intended for the use of our clients and colleagues. Material may not be reproduced, forwarded or shared without express permission.
We continue a discussion of Exchange Traded Funds (ETFs) in this issue of IntelDigest. ETFs are low-cost, “passive” investment funds which track particular benchmark indices.
Exchange Traded Funds
The number of ETFs has grown to almost 5,000 globally … approximately 2,000 in the U.S. … and continues to rise. This is greater than the number of publicly-traded stocks.
ETFs represent an important investment tool for all investors, but especially those looking for an easy way to invest in a particular geographic region, market, sector, etc. ETFs are simple to understand, and appeal to investors who may have been disappointed by the relatively high fees and underperformance of “active” funds, where fund managers select stocks to include in the fund.
The amount of assets under management (AUM) held in ETFs now exceeds $3.4 Trillion, a 17-fold increase since 2003. The growth of these funds … both in number and assets … has been staggering.
In the era of smartphones, we are accustomed to saying “There’s an app for that.” There is now an Exchange Traded Fund for virtually all asset classes, many of them very narrowly focused. For example, there’s now an ETF that focuses investment only on companies in the ETF industry! Some very small, niche-market ETFs have attracted significant capital.
The Downside of ETFs
The growth of ETFs is part of the larger trend of “passive investing.” But, there is a potential downside to passive investing, and some unintended consequences.
“Passive investing” means using a “buy-and-hold” strategy by investing in an exchange traded fund or index fund which simply tracks an index. We are experiencing a boom in passive investing. Over 40 percent of all funds under management in U.S. equities are passive investments; by some Industry estimates, that number will grow to 50 percent by 2018.
At some point, if too many investors follow the same benchmark, the benchmark becomes the tail that wags the dog. The flood of money into index-tracking funds has a huge impact on overall market liquidity, and is distorting the valuation of stocks.
Consider that Vanguard Group (one of the largest investment companies in the world) now owns five percent or more of 491 stocks in the S&P 500. And,
Vanguard now owns almost seven percent of the entire index, according to the Financial Times. Since 2009, investment clients at Bank of America have dumped $200 Billion of individual stocks, and purchased $160 Billion of ETFs
ETFs now comprise 24 percent of trading in U.S. equities, according to the Financial Times.
Cause for Concern
There is concern on Wall Street that passive investing is undermining basic market principles … share prices of good companies should rise in value as their businesses grow, and bad companies should go bust. The grandfather of passive investing, Vanguard Group founder John C. Bogle, thinks that indexing can get too big for its own good. “What happens when everybody indexes?” he asks. “Chaos, chaos without limit. You can’t buy or sell; there is no liquidity, there is no market.”
With passive investing, many investors focus less on company fundamentals. They throw their money at index funds, rather than doing the hard work of determining which companies are well-run and growing, which shares are cheap and which are overvalued.
Too often, no one is “kicking the tires” on sectors or companies to examine fundamentals. Passive funds simply invest in dozens or hundreds of stocks at a time, with capital allocated to each stock depending on nothing more than their market capitalization.
In a recent Wall Street Journal article titled, “The Dying Business of Picking Stocks”:
“Passive funds are designed only to match the markets, so investors are giving up the chance to outperform them. And, if fewer managers are drilling into financial reports to pick the best stocks and avoid the worst – index funds buy stocks blindly – that could eventually undermine the market’s capacity to price shares efficiently.”
How to Invest
As in all things, Moderation is the key. Take advantage of the ease and low cost of exchange traded funds, but don’t use them exclusively.
Always do your homework with ETFs, just as you would with any individual stock. Read the prospectus, and know exactly what index the ETF tracks, and how closely. Some ETFs suffer from “tracking error,” so don’t assume anything … read the reports!
Be skeptical of exotic ETFs. As the ETF market has grown, sponsors have developed more exotic … and risky … products to stand out in the increasingly-crowded field. Some of the most risky are the “Leveraged” ETFs which seek to double or triple the returns of an index, and “Inverse” ETFs which seek returns in the opposite direction from an index (for example, if the underlying index goes down, the ETF goes up). These ETFs use “derivatives.” You remember reading about those in the context of the 2008 Financial Crisis!
If you are not an investing professional, your best strategy is still Diversification. Spread your eggs among several baskets … and watch the baskets closely! That is still the time-honored method of earning good returns in complex and uncertain markets.