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The Rise of Passive ETFs
Arguably, the most important quality in being a skilled investor is having the confidence to be contrarian – and increasing your position on the other side of a crowded trade when you have strong conviction. For many years, the financial media and professional investors, including the likes of Warren Buffett and Jack Bogle, have been strong advocates for retail investors to utilize a “buy and hold” strategy encompassing low cost, passive index ETFs due to their more recent period of out-performance relative to higher cost, actively managed products. According to data compiled by ICI Global, passively managed, domestic ETFs represent about 8.89% of the S&P 500 index’s market cap as of May 2018. While this may not seem like a very high proportion of the overall market, the Vanguard S&P 500 ETF has grown by 178.73% over the last 5-year period and the year-over-year growth for all U.S. ETFs was 21.10%. But what if the advice of many professionals has been more of a marketing gimmick that has slowly led to many individual stocks held by ETFs in high concentrations to deviate from their fundamental value, leaving those with less passive fund exposure as more attractive investments? With Netflix, Amazon, Apple, and Netflix having accounted for roughly 80% of the S&P 500’s returns in 2018, it seems as if investors are asleep at the wheel, having little understanding of the makeup of passive fund out-performance. Although these funds have provided investors with superior returns over the last decade, given the late stage of our economic cycle and the exponential market share growth of passive ETFs over the past several years, I believe investors are not properly assessing the risks of owning them during a large market draw-down.
Potential Conflicts of Interest and Suitability
Passive ETFs have often been marketed as a conflict-free way for a fiduciary to achieve client diversification and maintain low-cost. The fiduciary rule attempted to rid the financial services industry of sleazy salesmen earning excessive, front-loaded fee commissions on complex products that may not necessarily be in a client’s best interest. However, the rule is very subjective when it comes to ETF suitability. What specific criteria determines whether an investment is in a client’s best interest? Obviously selling unsuitable and excessively priced products to clients is unethical, but suitability depends on a variety of factors – largely the advisor’s market outlook and many other perceived risks. Therefore, low fees and diversification benefits associated with passive products should not be main factors in suitability judgment, and these benefits do not lead to lower total risk than alternative vehicles. Firms have a huge incentive to sell passive investing to retail investors because they can more efficiently automate their processes and essentially eliminate research expenses, since many funds require no decision making by the manager. Although economies of scale enable firms the ability to lower fees, the lack of fundamental security due diligence also decreases the advisor’s fiduciary responsibility. The growth of ETFs has increased the risks of ownership, and they could be considered as unsuitable products for many investors. Lower fees do not correlate to superior products, and passive funds should be held to a higher suitability standard.
ETF growth has also provided enormous control to agencies such as S&P Dow Jones Indices LLC. A joint venture between S&P Global, the CME Group, and News Corp, S&P Dow Jones Indices determines the components of all S&P Indices, including specific sector compositions. According to documentation published regarding index construction and methodology, there are extremely broad criteria that go into constituent selection and almost none are based on an underlying company’s fundamentals. This makes the process very subjective and opens the door to potential conflicts of interest since all three companies in the joint venture are publicly traded.
Academic research has shown that a stock which is added to the index has a material implication on that stock’s share price. Between 1990 and 2015, the average excess return on a stock added to the index from the time of announcement to the inclusion effective date was 5.64%. Given the growth in ETFs which mimic S&P indices, the agency has too much influence over both individual company liquidity and retail investor returns, indicating a need for greater transparency in component selection.
Managing Downside Risk
Retail investors have a long history of distrust for the financial services industry. Many investors that exited their positions in 2009 have slowly crept back into the market using passive fund ownership. These investors were sold on passive vehicles as a form of “fair” investing, where buy and hold ownership results in equal benefit when the economy is doing well, and equal loss when it is not – and that active managers cannot out-perform this strategy. This herd mentality has fueled the S&P 500’s out-performance of active funds during the recent bull market run, but a prolonged market correction resulting in outflows could occur at the same velocity. To generate out-performance under this scenario, investors will need to allocate their portfolios towards strategies that invest in high quality companies with compelling economic valuations.
Dow Jones Indices publishes a risk-adjusted scorecard comparing actively managed mutual funds to their respective S&P benchmarks where it concludes that 95.03% of actively managed, large-cap mutual funds under-performed their S&P 500 benchmark over the 15-year period from 2003 to 2017, on a net of fees basis. Although the data appears convincing and has gotten much financial media coverage, there are biases used in compiling it which make their conclusion misleading.
First, their analysis only takes into consideration 40 Act mutual funds, which is not an accurate comparison to all actively managed products. Second, the analysis defines risk as the standard deviation of monthly returns, or portfolio volatility. At the end of a bull market, investors should be more worried about managing the downside risk rather than monthly volatility. Therefore, since mutual funds do not have the ability to manage downside risk, a more accurate risk-adjusted performance comparison should be made to a hedge fund index using the downside variance, or Sortino ratio. Finally, the 15-year period analyzed conveniently begins in 2003, which was the beginning of the bull market run after the dot-com crash. Instead, data encompassing two recessions and two bull markets would make for a much more accurate comparison.
The graph above shows the yearly relative performance of the Eurekahedge Hedge Fund Index performance relative to the S&P 500 since 2000. During this period, the stock market has experienced 2 bear markets – one from 2000 to 2002 and one from 2008 to 2009. As you can see, since the financial crisis in 2009, the S&P 500 has outperformed this index on a relative basis by a whopping 48.83%. However, during the combined 5-year periods in which the two draw-downs occurred, the Eurekahedge Hedge Fund Index out-performed the S&P 500 by 112.04%, leading to a total out-performance of 76.03% from January 2000 to May 2018. The data shows that during a bull market, especially one magnified by tremendous passive ETF flow growth, it is tough for active managers to out-perform the S&P 500 since many stocks in the index get a boost from flows, making it hard for hedge funds to generate alpha – but lower draw-downs lead to hedge fund out-performance over longer periods.
Although the US economy appears to show bullish signs in the near term given the tailwind from corporate tax reform, many companies are not taking advantage of the additional cash flow for deleveraging. As interest rates rise, companies that commit to a sustainable financial position and continue to generate strong cash flow will have far more flexibility in their ability to place a floor in their share price in the form of capital return. These companies will suddenly return to favor, and once again valuation, quality, and managing downside risk will matter.
Investors in passive ETFs have generated high returns during this massive bull market run since 2009. However, low-cost diversification does not imply sustained out-performance if the portfolio contains less quality relative to alternatives. We are now in uncharted territory in the credit market – and due to easy money Fed polices and perhaps loosely monitored credit ratings agencies that have resulted in over-extended corporate balance sheets, it is time to be skeptical of many passive ETFs. We are already seeing cracks in both high-yield and emerging markets as investors reassess the underlying fundamentals. There will eventually be a flight to high-quality companies which are returning capital to shareholders, under-owned by index funds, and under-valued relative to their peers. Investors should be proactive by rotating into this area, as these companies should provide a greater margin of safety.
Disclosure: I am/we are long AAPL.
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.