The Risks Of ETFs Are Greatly Underestimated

by: Bram de Haas

Summary

Why indexes combine the worst of two worlds.

Rumors of indexes beating active managers are greatly exaggerated.

ETF investors are not aware what kind of risks they are running.

Cullen Roche is one of the most interesting investment writers and I read his stuff almost without fail. When I fail that is on me. I don’t always agree on everything and his latest defense of the indexation trend deserves a rebuttal.

His main point being critics are overplaying the risks of the indexation trend. I’m one of those critics after having cheered on the adoption of ETFs until about 2015.

Roche describes the S&P 500 as an incredibly strict set of rules that is designed and maintained by people. He dismisses criticism on this setup as mistakenly focused on the mechanical aspect while he views the combined input of real people and strict rules as mostly favorable and culminating in a low fee active fund:

But we should be very clear about what’s going on here – there are people setting the rules and ultimately determining what the S&P 500 is comprised of. If you weren’t blinded by the fake “active vs. passive” dichotomy you’d look at this index fund and say it was a low fee active fund which is exactly what it is.²

In my view the strict rule system allows more active market participants to take advantage of an ETF while the ETF managers response comes only after the damage has been done. For example if a company breaks a rule for inclusion short sellers can pounce on it knowing it will be sold off by the index at the next rebalancing. Communicating what your actual follow through will be to an event ahead of time, and following through without fail, can only result in a an assymetric disadvantage.

What about this idea that ETFs and index funds are more dangerous during bear markets? We’ve had some pretty big bear markets in the last 15 years and the share of active managers who beat the index does not support this claim:

  • 2001: 35%

  • 2002: 32%

  • 2008: 44%

In 2001 and 2002 ETFs were not widespread while one of the problems today is that their widespread adoption contributes to mispricing which is likely to be corrected only after a sell-off.

One of the problems critics like myself, Heisenberg (especially high-yield) or Horizon Kinetcs (leading ETF critics, see also HK’s Steven Bregman debating Jack Bogle) are identifying is that ETFs will enhance losses for naive owners.

Now that they consist of a sizeable chunk of U.S. invested assets this will be tested. The fear is that ETFs will get sold off on in response to sharp market drawdowns which will induce more selling. In that process the ETF may start to diverge in a meaningful way from the Net Asset Value of the underlying securities, which is hard to keep track of for most investors, and people will continue liquidating at prices that will lead to deep underperformance of that very same index. You can fault the individual investor for that after the fact. I rather warn them before the fact.

Many people investing in indexes are going to lag that same index. The index itself of course will never lag itself or only by a marginal amount. Even aside from such details whether the index is so great compared to “true active investing” is something that remains to be seen.

I use the term true active investing because the whole comparison between active investors and passive investing doesn’t make a lot of sense when at least 20% of "active managers" is closet indexing and only a small percentage of active managers really lives up to the name. If you look at the performance of a simple subset of active managers things are immediately looking very different.

With ETFs and index funds there are more and more individual owners of assets who are playing the role of portfolio manager. Will they respond better than the average portfolio manager when the sh*t hits the fan? I seriously doubt it. But again, don’t blame the product for the product user’s mistakes. As we saw during the flash crash of 2015 these ETFs operated EXACTLY as they were supposed to. But many people overreacted due to sheer emotion.

My message isn’t necessarily ETFs are an inherently bad product but I want to caution people the idea investing in these things is guaranteed to result in a satisfying investment experience. They are specifically designed to exhibit a history of deceivingly low volatility. I believe holders of low-volatility ETFs, junk bond ETFs, other popular but narrow ETFs and perhaps even vanilla S&P 500 ETFs are unwittingly taking on a lot of risk.

Disclosure: I am/we are short SPLV.

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.

Additional disclosure: I'm not actually short the SPLV but a close equivalent by the ISIN of IE00B802KR88