What Impact Will ETFs Have on Future Market Activity?

 |  Includes: DBC, DJP, EEM, EWZ, GSG, VWO, VXX, VXZ, XXV
by: Morningstar

By Scott Burns

In today's hyperintensive securities markets we can find a lot of corollaries to the highest echelons of science. One of my favorites is a theorem in quantum mechanics known as the Heisenberg uncertainty principle. This theorem revolutionized our understanding of the behavior of particles at the atomic level and ultimately led to the Nuclear Age.

There are a lot of different pieces to this theorem, but the most applicable to modern finance is the portion that essentially states that the act of trying to measure a particle changes how that particle behaves and ultimately makes it impossible to predict the particle's future behavior.

For investing, I would substitute "act of investing" for the "act of trying to measure." We have seen throughout history the impact of the market identifying an opportunity, pouring money into that opportunity, and ultimately creating a future investment outcome that differs vastly from historical behavior.

One of the clearest examples of this is what happened to the size premium that is key to the Fama-French three-factor return model. Prior to Fama and French publishing their seminal paper, small-cap companies actually provided outsized risk-adjusted returns relative to their large-cap counterparts. To avoid confusion, small-cap companies should provide more return on average than large-cap companies because there is inherently more risk in small-cap companies. What Fama-French found was that small caps were receiving risk premium--and hence return--above and beyond what their actual risk should require in an efficient market. Things moved a little slower in the 1980s, but eventually the market seized upon this inefficiency, money poured into small-cap names, and the excess returns collapsed during the course of five to 10 years.

In the case of the size premium, it was an act of measurement and awareness that led to a change in investor behavior and ultimately changed the benefit of owning small-cap names. Fast-forward 20 years, and we find a new change agent affecting the investment landscape: exchange-traded funds.

For ETFs, the impact will not be the result of measurement, but of access. One of the great benefits of ETFs has been how they've democratized investing, but, like all things, we are starting to see the unintended consequences of those actions. The question that is often on my mind is what aspects of the investing world will be most subject to this "act of investing" effect. That is, what are the areas where we should consider throwing out all that we know historically and gird ourselves for a new reality that has been changed by the onslaught of new assets chasing returns through ETFs?

My colleague touched on this before, and I just want to briefly weigh in on the subject. There is a debate as to whether commodity ETFs and the increase in financial investors have changed the dynamic of this market. I think they have, but the size of the impact is still undetermined. I believe that the rush of money into commodity ETFs has thrown the system slightly out of whack and that we have some supply and demand imbalances in the commodity market as a result.

When commodity proponents talk about the power of the assets as portfolio diversifiers, they use a historical record that generally showed the major commodity areas in states of backwardation. Now that we have seen three years of rather persistent contango and a negative roll-yield situation, those assumptions are coming into doubt. Are ETFs the sole cause of contango? Not necessarily, but the rush of money into very specific parts of the futures curve is not helping matters.

Whether commodities retain their diversification prowess is going to have a lot to do with getting those futures curves back into backwardation. Remember, for something to enhance a portfolio, it has to not only have low correlation with the rest of the holdings, but it also needs to generate a positive return.

Volatility Products
Similar to commodities, the current lineup of volatility- or VIX-tracking products would seem to have had an unintended impact on the shape of the futures curve in that space. When the VIX exchange-traded notes first came out, we were as excited as we have ever been over a new product launch. However, what had been a pretty consistent negative roll yield of 3%-5% a year turned into a negative roll yield of up to 20%. A negative roll yield of 3% can be looked at as an insurance premium. A negative roll yield of 20% is throwing money down the commode for the long-term investor. It can't just be coincidence that shortly after those products launched the yield curve for VIX futures steepened like it did.

Brazil and Emerging Markets
Here's a fund fact for you: At roughly $9 billion dollars, iShares MSCI Brazil (NYSEARCA:EWZ) accounts for nearly 1.5% of the total assets on the Brazilian BOVESPA exchange. EWZ, combined with emerging-markets juggernauts iShares MSCI Emerging Markets (NYSEARCA:EEM) and Vanguard Emerging Markets ETF (NYSEARCA:VWO), owns approximately 2.5% of the Brazilian market. Given how much trading activity occurs in these funds, one can estimate that the represented share of trading volume on Brazilian stocks could be as high as 20% of total daily volume.

Given that so much of the Brazilian market is in the hands of ETF investors, we can expect the price fluctuations of Brazil and other emerging-markets nations to more reflect investor sentiment in developed markets rather than anything happening with the fundamentals of Brazilian equities. We saw this at the end of 2008, when assets rushed out of these ETFs and the local stock markets were crushed, despite the fact that the fortunes of local companies--banks in particular--were nowhere near in as bad a shape as what developed markets were facing. For the strategic investor, the increase in correlation is problematic and will affect asset-allocation decisions. For the tactical investor, this is a good thing because these dislocations for the fundamentals produce excellent buying opportunities.

Passive Investing
What happens if every investor switches to passive investing? The implicit question asks how prices will be set in the market if everyone settles for just "average" in their investment portfolio. Jack Bogle used to respond to this question by saying we are a long way from that happening, but that bit of deflection may have run its course. A recent survey by Morningstar found that ETFs and index mutual funds accounted for more than 22% of assets under management in 2009, up from 11% in 1999.

As this trend continues, we can expect a couple of things to happen. The price movements of individual securities will become more and more linked to broad investor sentiment. Yes, more than what already exists. Asset management is a zero-sum game; for passive funds to have assets, someone needs to lose assets. My guess is that the biggest losers in this shift will be the fund managers that are commonly referred to as shadow, or closet, indexers. The market will shift assets away from these high-fee and low-impact managers and into low-cost ETFs. This will create what I think will ultimately be a barbell-shaped return pattern for active managers that are taking on concentrated risks and delivering returns that massively beat the market or massively miss. If this happens, investors paying for active management will get what they paid for, good or bad.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.