As I write almost exclusively on the topic of ETFs and mutual funds and have a website called ETF Focus, it's probably not difficult to assume that I'm an ardent defender of ETFs and how they've become perhaps the single best thing to happen to the average investor since, well, the mutual fund! With total ETF assets having just passed the $3 trillion mark at the end of March, I think it's safe to say that ETFs have found their place in the investing community.
Which is why I was a little surprised when I found multiple articles this weekend talking about the problems with ETF investing and why, in some cases, investors should avoid them altogether. To be fair, I don't think ETFs are perfect investments. Some funds have unnecessarily high fees, are overconcentrated or target incredibly narrow market niches. Leveraged and inverse ETFs also have the potential to cause trouble if they're not used properly. But overall I think the evolution of the ETF industry has been a very good thing for investors looking to target specific strategies or markets. It's also been great for folks who aren't money savvy and are just looking to make a simple long-term investment.
In order to be fair, I think it's worth examining some of the criticisms of ETFs pointed out in these articles to determine if, in fact, they are problematic. The funds I listed above are examples of where I think the underlying issue is the fund itself, but I believe the massive exodus from actively managed funds over to passive index funds is creating a few unintended consequences that should be considered.
I want to take a look at four major issues brought up in these articles one by one to try to determine the scope of the problem and if I think there even is one.
Inflows Into Passive Funds Are Making The Markets Inefficient
I think this is true to a degree but I also think the issue of inefficiency has more to do with investors chasing performance than anything related to ETFs specifically. Investors have a long history of making investment decisions based on recent past returns and the fear of missing out on potential future returns. Study after study has shown that these folks by and large get in and out of the market at the wrong times and end up severely hindering the returns they see on their investments.
While ETFs have given investors easier access to just about any market, sector, region or niche they want to invest in, the true inefficiency, I'd argue, is investor behavior. The ETF boom is a relatively recent phenomenon but mutual funds offering similar passive strategies have been around for several decades. And there's also the fact that despite the wave of new money heading into index funds, nearly two-thirds of total fund assets are still in actively managed funds.
Inflows Into S&P 500 Funds Are Inflating Valuations
It's unfair to blame the high valuations in the stock market on ETFs although to be fair I think it could be a contributing factor. As more focus has been put on how financially ill-prepared people generally are, advisors and employers have taken to tactics such as automatic investing plans and automatic 401(k) enrollment to boost savings rates. Much of that is directed to broad market index funds and S&P 500 index funds in particular. With that much money flowing into these indices, it's bound to provide some level of support for the equity markets.
But there are other factors to consider. The 10-year Treasury rate remains at near historically low levels. Lower interest rates support higher valuations and this article suggests that the stock market is pretty fairly valued right now with interest rates where they are.
Consider the following chart...
Looking back at the past five or so years, P/E ratios have grown from the 10-14 range up to the current 17-20 area. That expansion occurred during a time when the economy was still recovering from the post-financial crisis period. Economic growth combined with interest rates that were already low at the time meant that a market rally due to multiple expansion was a reasonable expectation. The Trump pro-growth agenda is a more recent example of an outside factor that expanded multiples. Passive ETF inflows certainly results in a steady demand for equities but there are a lot of factors at play.
Passive Investing Has Increased Correlations Across Stocks
I can sort of buy into this argument. Looking back over the past two years, the three funds with the greatest net inflow are the SPDR S&P 500 ETF (NYSEARCA:SPY), the Vanguard S&P 500 ETF (NYSEARCA:VOO) and the iShares Core S&P 500 ETF (NYSEARCA:IVV).
That's a lot of investment dollars being put to work in the same basket of stocks. That's 500 different companies whose stocks are being purchased and sold at the same time. Considering that nearly 30% of trading volume comes from S&P 500 ETFs, it's easy to see how a lot of these stocks can tend to move together.
That being said, it's easy to see how different sectors perform very differently across both short- and long-term time frames. I think if the major sectors began rising and falling together and the difference in performance between such sectors was narrower, this might be more of a concern. Given that this really isn't the case, I don't believe it's an issue yet.
Avoid ETFs And Index Funds Entirely
There are two ways to approach this point. Is the author suggesting that passive ETFs should be avoided because the market is overvalued or should they be avoided because they are bad products. The answer to the first is maybe depending on where your own research lands. The answer to the second is definitely not.
To most of the world, investing is largely confusing and maybe even scary. ETFs, like mutual funds, are a great way for these folks to participate in a simple long-term investment strategy without having to dig too deep. They are broadly diversified, easy to trade and extremely cheap. Even sophisticated investors benefit from one-stop access to just about any sliver of the market they can imagine. ETFs aren't perfect in all cases but their presence in the marketplace has certainly been a big step forward for the investing community as a whole.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.