One of the recurring themes on this website over the past two years has been the growing threat posed by the flood of capital out of active investing and into passive, and far cheaper and better performing (under central planning) vehicles such as ETF.
For a quick rundown, here are some recent posts on the topic:
- What Would Happen If ETF Holders Sold All At Once? Howard Marks Explains
- JPM Warns Shift To Passive Investing Increases Systemic Risk, Will Make Crashes Worse
- Which Hedge Funds Are The Biggest Holders Of ETFs
- Scientific Proof ETFs Make Markets Dumber
- Market Absurdity Squared: There Is Now An ETF ETF
- Hedge Fund CIO: "Expect Enormous Losses In The Next Correction As There Is No Price Discovery In Index Investing"
Now there is an even more vocal warning. According to Arik Ahitov and Dennis Bryan, who run the $789 million fund FPA Capital, and who have taken a page right out of the Warren Buffett warning books, Exchange-traded funds are “weapons of mass destruction” that have distorted stock prices and created the potential for a market selloff.
In the April 6 letter seen by Bloomberg, the two write that "When the world decides that there is no need for fundamental research and investors can just blindly purchase index funds and ETFs without any regard to valuation, we say the time to be fearful is now." While somewhat different from Buffett's original warning, who famously called derivatives the original weapons of financial mass destruction, on many occasions we, and others, have shown the growing liquidity mismatch between the instrument and the underlying, in effect making ETFs a quasi-derivative instrument, thus allowing convergence between the two warnings.
Going back to the letter, the underlying lament is familiar to regular readers who have read our thoughts on ETFs:
The flood of money into passive products is making stock prices move in lockstep and creating markets increasingly divorced from underlying fundamentals, the managers said. As the market moves ever higher, there’s the potential for a sharp decline. The U.S. ETF market has about $2.7 trillion in assets, the majority in products that track indexes. ETFs have attracted more than $160 billion in new flows so far this year, Bloomberg data show.
“This new market structure hasn’t been tested,” Bryan said in a telephone interview, noting that the stock market has never gone through a major downturn when passive investors were as important as they are now. “We could get an onslaught of selling.”
To be sure, there may be a slight conflict of scapegoating interest involved. As Bloomberg observes, for more than two decades under former manager Robert Rodriguez, Los Angeles-based FPA Capital was among the top-performing stock funds in the U.S. From 1986 to 2010, it returned 14.5% a year compared to 8.5 percent for the Russell 2000 Index. That's when the good times ended and since 2010 the fund has struggled, in part, because the managers, finding too few attractive stocks to buy, have parked 35% of their money in cash.
"FPA Capital trailed 99 percent of peers over the past five years, according to data compiled by Bloomberg. The fund is a concentrated stock fund. Its biggest equity holding as of March 31 was Western Digital Corp., which makes computer-storage devices."
In other words, a pure-play concentrated alpha generator. Or so it would hope. And naturally in an environment where everything rises or falls at the same time, such strategies are a recipe for terminal redemptions. It is only logical that in a time of declining returns, fund managers will blame anything and everything that is available, and recently that means attacking ETFs.
Still, it doesn't make FPA's lament wrong: others have voiced similar concerns. In a February letter to investors, Seth Klarman, who runs the $30 billion Baupost Group, said that as more investors opt for passive investing over active management “the more inefficient the market is likely to become."
In the same letter, Klarman cited Nikolaos Panigirtzoglou, a global market strategist at JPMorgan Chase in London, who, according to Klarman, has warned that the inflows into ETFS will “make markets more brittle” and “susceptible to more severe crashes.”
Others such as Eric Peters, CIO of One River Asset Management made a similarly stark warning in an email to clients:
“There is no such thing as price discovery in index investing.” And there will be no price discovery on the downside either. The stocks that have been blindly bought on the way up will be blindly sold. “When these markets do finally have a correction there will be no bid for many of these stocks.”
“The people who are indexing now are the same ones who were selling in 2009,” continued VICE, agitated. “I just spoke at a conference filled for wealth advisors from all the major players. They say the same thing - today’s buyers are not long-term investors.” They’re guys who put $1mm into index ETFs. “When they lose 6%-7% and decide to sell, who will be on the other side of those trades?” And the stocks that will be savaged worst will be the ones that lagged the indexes on the way up. “It reminds me of 2000, when people piled into the QQQs.”
“I don’t know when the next major crisis will hit, no one does,” admitted VICE. “But I do know that even in the next normal correction, the market’s losses will be amplified enormously by this move away from active management.”
On the other side of the argument are those who profit the most from the current passive to active "great rotation" such as Jim Rowley, senior investment strategist at Vanguard Group, one of the world's biggest ETF fund flow recipients. Predictably, Rowley disagrees with the naysayers. Vanguard, which has roughly $3 trillion in assets in passive products, including almost $700 billion in ETFs, has examined more than 20 years of market history, he said. The conclusion: markets are as volatile as ever and the dispersion in the performance of individual stocks is as great as it was before indexing became popular.
“We didn’t find any relationship between indexing and market dynamics,” he said.
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For now, the debate about the impact of ETFs rages, and will do so inconclusively as long as trillions in central bank liquidity prop up broader risk assets and equity markets. It is only once central banks take start soaking up some $18 trillion in excess liquidity that the true impact of ETFs will be visible. Until then, we leave readers with thoughts from the abovementioned note by JPM's Nikolaos Panigirtzoglou, first reported here last October, and summarized below, on what the take over by ETFs really means:
- Markets become more brittle, risky: "The shift towards passive funds has the potential to concentrate investments to a few large products. This concentration potentially increases systemic risk making markets more susceptible to the flows of a few large passive products."
- Passive or index investing favours large caps as most equity indices are market cap weighted. "This could exacerbate the flow into large companies beyond to what is justified by fundamentals, creating potential misallocation of capital away from smaller companies. To the extent that these passive funds become even more dominant in the future, the risk of bubbles being formed in large companies, at the same time crowding out investments from smaller firms, would significantly increase."
- The proliferation of index funds increases the size of stock inclusion flows. In turn, market moves around index constituent changes become more pronounced overpenalizing companies leaving the index and causing excessive gains to companies entering the index.
- Crashes, when they happen, will be bigger and badder: "the shift towards passive funds tends to intensify following periods of strong market performance as active managers underperform in such periods of strong market performance. In turn, this shift exacerbates the market uptrend creating more protracted periods of low volatility and momentum. When markets eventually reverse, the correction becomes deeper and volatility rises as money flows away from passive funds back towards active managers who tend to outperform in periods of weak market performance."
- Markets become less efficient: "if passive investing becomes too big, potentially crowding out skilled active managers also, market efficiency would start declining. In turn, this would present opportunities for active managers to extract arbitrage profits."