F. Scott Fitzgerald may have said there were no great second acts in American lives, but clearly he wasn’t reckoning with Michael Burry of “The Big Short” fame, who’s out with a new prophecy warning of the evils of passive investments. In a long email interview with Bloomberg, "The Big Short’s Michael Burry Explains Why Index Funds Are Like Subprime CDOs," Burry joins the chorus of other famous investors who warn that the steady flow of investor assets into index funds is distorting the market by interfering with the process of price discovery, especially for the smaller names in major indices like the Russell 2000. Burry is of the opinion that the longer this trend continues, the worse the inevitable downturn will be as investors flee index funds, which puts more downward pressure on stock prices.
Burry has certainly touched a nerve, with critics quickly dismissing him by pointing out that he is engaging in a bit of self-promoting, as he does manage an RIA focused on exploiting market anomalies such as small-cap value stocks, while others praise his intelligence and past success. We’d suggest both sides call us to ask about our constituent data feed - something we’ve already talked about here on Seeking Alpha, where we have access to the actual daily holding reports for thousands of ETPs offering unique insights into how the intersection of fund flows and active investors plays out.
We’re going to sit out this debate, but we decided that after one of the most volatile Augusts in recent memory, we should use our constituent data for lessons that both sides can rely on. And what did we take away? Namely that investors should be careful about making assumptions about the impact of ETPs on individual stocks.
Regular readers will know we offer numerous data feeds for our institutional clients, with the constituent data being among the most popular. It’s derived from the most recent holdings reports for thousands of ETPs from across the globe, giving us the ability to see the change in ETP ownership of individual securities on a daily basis. In the past, we’ve used this feed to talk about how strong inflows into certain products was impacting specific stocks such as Aqua America (WTR) ("Aqua America Update: The Calm Before The Storm"), but with this Burry-induced debate over the role of ETPs, it seems to be the best time to take a deeper dive into the latest trends.
To do that, we decided to do a quick and dirty experiment using a stock screening tool easily available to most investors at Finviz.com. We used their screener to download a file with all publicly traded U.S. stocks (excluding certain products like trusts or closed-end funds) and match that with our constituent data to determine how the recent volatility was shifting the market. That provides us with a more nuanced industry breakdown, while also giving our readers an easy-to-access and cost-effective screening tool that they can use.
To help distinguish between the effect of ETP purchases and price appreciation, we continue to focus on share purchases, so our ETF ownership % looks at the number of shares held by different funds compared to the floating number of shares for each company. We also want to focus on the ETP impact on stocks based on market capitalization, which required setting break points using guidance from a number of index providers like FTSE Russell and S&P to determine the nano through large-cap brackets which you can see in the table below.
So, what did we learn from our little jaunt through the data fields? We think there are three key takeaways for Mr. Burry or anyone who’s looking to exploit the ETP effect by focusing on smaller-cap stocks.
1. ETPs love Small-Cap Stocks
Maybe the most striking observation from our little study was that the stocks in our third bracket, those with market caps between $300 million and $2 billion, are hardly suffering from a lack of ETP ownership. Those small-cap stocks have an average ETP ownership of 14.94%, compared to nearly 17% for mid-caps and just under 14% for large-cap stocks. Obviously, you can slice that large pool of names into any number of different size brackets, with the ETP ownership percentage steadily dwindling as you get closer to the micro-cap names, which we defined as those with market caps between $50 and $300 million. In this case, the average ETP ownership percentage drops precipitately, down to under 7% across all industries.
So, seeking safety, or more stock-specific risk, from ETP flows is anything but guaranteed by shifting into smaller names. But saying that makes us guilty of broad generalizations, so what can we learn from an industry focus?
2. Industries Matter
Another important distinction investors have to remember is that working with averages can be deeply misleading, especially when you look at ETP ownership. One virtue of Finviz’s dataset is the ability to parse down your investment universe into very specific industries for a much more nuanced take on the market. And here you can find even more fuel for your ETP opinions.
Within small-cap stocks, we found that the percentage of ETP ownership ranges from the low single digits like gaming activities to north of 30% for cigarettes, although both categories are relatively narrow with just one company, Vector Group Ltd. (VGR), in the small-cap cigarette industry, while one gaming stock, Scientific Games Corporation (SGMS), is more lightly owned. What explains the difference between the two companies that account for that? It’s not in the broad index funds that make up most of the ETP market, but in the dividend funds which are often among the second-largest owners of some stocks.
VGR is heavily owned by several dividend funds like the Invesco High Yield Equity Dividend Achievers ETF (PEY), which gives it added liquidity and we believe helps dampen volatility. And continuing inflows into dividend-paying funds helps to increase the buying support for names like VGR versus the broader small-cap universe (here represented by IJR), although whether that can help wash out the impact from investors leaving broader index funds in the event of a pullback remains to be seen.
3. Know Your Flows
Although Burry and others are concerned about the impact of ETPs on price discovery, namely that investors buying index funds will distort the impact of active management, the fact is that the universe of ETPs is anything but uniform. In a recent post on Aqua America, we showed the broad index funds replicating the S&P 600 controlled the largest number of shares, but an extensive array of dividend, utility, and even thematic funds were also major holders. And those funds, influenced by the ever-shifting demand for dividends or sector rotation strategies, often played the role of “active” management among ETP holders, with many small- and mid-cap utilities companies seeing their ETP ownership percentage steadily increase in 2019 as investors turned bearish on the market.
Utilities are hardly the only example of this; any concentrated industry can be susceptible to this, or even a non-concentrated one like the biotechnology sector, where incredibly strong flows can lead to major ETP activity, even if it goes against a major trend. You can see this in action with two small-cap mining stocks, Hecla Mining (HL) and Coeur Mining (CDE), which are both included in multiple precious metal funds, including the VanEck Vectors Gold Miners ETF (GDX), junior miners like GDXJ and in even larger amounts in the Global X Silver Miners ETF (SIL). Precious metal miners may be among the best-performing funds in 2019, but it’s a different story when you drill down the fund level.
Both HL and CDE saw a decline in the number of their shares held by ETPs in August by 2.8 million and 7.2 million shares respectively, even as the mining funds saw further gains for the month. The culprit? Strong outflows from GDX and GDXJ that were partly offset by continued inflows into SIL as investors drew down the asset pool of both funds, whether through short-covering or surrendering shares for the underlying assets. Both stocks still have ETP ownership above 25% of their outstanding shares as of the end of August, although large CDE is better able to weather the fund flow storm than HL. Newmont Mining (NEM), a large-cap component of GDX, was better able to survive the outflows thanks to the fact that it’s included in the S&P 500, which makes it a recipient of those large inflows that Burry and others worry are distorting the market.
Is there a final answer to the question of whether the rise of ETPs is putting investors at risk of a prolonged and bitter rout in the near future? Probably not - as we’ve pointed out, the impact of ETP fund flows is far more nuanced and can’t be summarized in a media-friendly sound bite. We’d suggest that the active decisions by investors to use different ETPs versus individual stocks isn’t so much a distortion of the market as simply the shape of things to come for active management.
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.
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