May 9, 2017    4 minute read

ETFs: the Blind Leading the Dumb?

The Flipside    May 9, 2017    4 minute read

ETFs: the Blind Leading the Dumb?

The market for exchange-traded funds (ETFs) has grown by approximately 28.75% this year, reaching $2.7trn, illustrating a rising appetite for this investment tool. In most cases, these numbers imply increasing confidence in the global financial markets as individuals pour their hard-earned cash into these funds.

The recent growth can be attributed to the comfort ETFs provide to the typical retail investor. Before the ETF boom in 2003, individual investors tended to go through an emotional rollercoaster. Now, with a single trade, it is possible to track an entire index.

The Undesirable Truth

Despite tremendous diversification and simplicity, ETFs are starting to contradict traditional value investing by distorting the true price of financial securities. As retail investors dive blindly into index funds without thinking about fundamentals, stock prices become inflated without rational justification.

This sentiment is shared by FPA Capital, a US-based value hedge fund which dubbed ETFs as “weapons of mass destruction“. Managers at this fund state that the market may be corrected in the form of a selloff, which can potentially trigger a downward spiral in prices. The epiphany may occur when investors start asking just how much they are prepared to pay for one dollar of a company’s earnings. Such a question can be answered by assessing the price-to-earnings ratio.

According to this metric, many companies in the S&P 500 seem to have a ridiculously expensive price tag. For example, large-cap US equities such as Facebook traded at a P/E ratio of 41.56 in 2016, while other companies exhibited a similarly high figure. The most popular exchange-traded fund by volume is the SPDR S&P 500 ETF, which contains a significant amount of stocks, trading at highly inflated ratios. As more people settle for such funds, the ratio is going to rise, making it difficult to assess the intrinsic value of individual companies, despite the public’s ardent belief in the efficient market hypothesis.

The Remedy

The key is to educate new investors to value investing and basic fundamentals. A new approach is likely to involve assessing the true value of a stock allied with certain principles. An exemplar of this attitude is Seth Klarman, who insists that “value investing is something that is in your blood.” His main philosophy distinguishes buying for value or simply following a trend. It seems that many individuals in the market are simply doing the latter by being pressured into buying before the market finally corrects itself.

Such behaviour can be illustrated by Snap’s recent IPO. A company which is considered to be an essential application for millions of people is, in fact, a loss maker, where its true value is inherently lower than the consensus of the market. The stock has promptly plunged 18.53% to reflect the company’s actual worth.

Once people start thinking of their portfolio as a basket of goods in a supermarket, they will begin shopping for something that seems like a bargain, rather than a product with flashy packaging. As this belief will start to prevail, stock picking will come back into fashion, instead of outright passive investing. Consequently, the market will move closer to the efficient equilibrium it desperately needs.

What Next?

Before the 2008 financial crisis, investors who deemed collateral debt obligations risky were frowned upon, as it was comparable to betting against the US economy. A similar reaction is likely to occur if the same is said for ETFs today. This reaction is a comforting lie, and risk should not be denied so easily. Some individuals compare exchange-traded funds to CDOs due to their ability to hide certain unfavourable products.

This can be said about certain types of ETFs which may contain complex instruments such as derivatives. As complexity increases, asymmetric information rises, potentially giving the impression of low-risk investments to retail investors. If the possible sellout happens, what would be the effect on the liquidity of the markets as investors pull out their money?

Conclusion

As with any relatively new financial product, regulation is imminent, especially after the 2008 fiasco. Therefore, ETFs are getting their very own set of rules. However, these rules are a complete antithesis of what would be expected. The new regulations aim to remove or modify certain rules created by the Obama administration, in an attempt to faster approve newly created ETFs. Therefore, the proliferation of these funds are likely to be facilitated by regulations, rather than halted.

Could one anticipate another Big Short in the next decade?

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