November 1, 2017    4 minute read

ETFs: How Dangerous Are They?

Dangerous Investments?    November 1, 2017    4 minute read

ETFs: How Dangerous Are They?

“Let me bring it down to reality…You guys woke up one morning in August (2015) and the Dow was down 1,090 points. And on that day a $40 billion ETF traded at a 30 percent discount….That should never happen, and if your client traded on that day, you will never get that back. Never. These funds may have low fees but they are not safe, and your clients need to understand that.”

Peter S Kraus, former Chairman and CEO of asset manager AllianceBernstein, famously proclaimed these words to a group of investment bankers in 2015, where he was keen to propagate his message on the dangers of passive investing. Kraus was released from his position at AllianceBernstein earlier this year, but what has become of his message? Has passive investing proven to be as much of a danger as he warned?

The Popularity of ETFs

If one were to look solely at the popularity of ETFs, then it would appear that Kraus was wrong. Exchange-traded funds have grown at an astounding rate. 2016 was a record year for ETF managers ,with $390bn being invested. 2017 has already surpassed this with over $100bn invested in the first two months of the year alone. Even the performance of ETFs has been astonishing.

Funds, such as a number of those managed by Direxion, who specialise in highly leveraged ETFs, are producing returns of well over 100% and leaving many investors highly satisfied with their investments. So it would appear that Kraus was wrong. Perhaps he was, as many critics claimed, an old-fashioned investor ill-prepared for the new investment age. This might not be the case, however. Worryingly, there are signs that Kraus’ message of doom may come to fruition, as there is speculation that ETFs are becoming more dangerous as they grow.

A popular approach of ETF managers that is causing increasing alarm is their selection process for equity fund content. Market capitalisation weighting is the investment tactic that involves allocating a number of shares into a fund that is in proportion to their company’s market capitalisation. For example, an ETF designed to track the FTSE 100 would have HSBC Holdings PLC as its highest allocated share.

The logic behind this technique is sound. A fund with market cap weighting should, theoretically, hold the same price change sensitivity as its tracked index, and should, therefore, offer an accurate reflection. Whilst this may be the case, it does lend itself to a key inherent danger. Through merely following the market, ETFs propagate all trends, including reinforcing the price of overvalued shares. This is especially dangerous, as the popularity of ETFs has grown. The more ETFs there are buying overvalued shares, the further the overvaluation of these shares is reinforced. With this happening at such a vast and increasing rate, as is the current trend with ETFs, the dangers of a bubble emerging are real.

Widespread Popularity

Whilst this facilitation of overvaluing is a danger with passive investing in general, not just ETFs, it is the widespread popularity of ETFs that sees them bare a large responsibility for this phenomenon. Providers such as Franklin Templeton Investments and State Street have recently slashed the prices of their funds. Moves such as these are clear encouragers for investors to become more heavily involved in ETF investing and, in turn, potentially contribute further to a growing danger.

On top of this, other factors are emerging which could perpetuate this danger further. Recent years have even seen the breakthrough of an ‘ETF of ETFs’, an ETF which consists of and tracks other ETFs. The structuring of these funds ensures that should a collapse occur, it will be strong. As the popularity of ETFs grows, so does their risk.

Conclusion

Overall, however, it is important to remember that – for now – ETFs have shown hugely positive results. They have defied the wildest expectations of many and are providing more than satisfactory returns for many investors. Despite this, Kraus’ warnings still lie looming, and they still could prove to be the monster under the bed for ETFs.

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