“Cause and Effect” is the relationship between events where one event is the result of the other or others. In most areas of life, we look for these
relationships. It should not be surprising that in the field of investment
management, we also look for cause and effect. We look for certain signals to determine when assets are overpriced or
underpriced, when to allocate among asset classes or optimal times and
strategies to trade assets. These
signals may be based on valuation, that is, buy assets when they are cheap and
sell when they are expensive. They may
be momentum-based or they may be based on growth prospects. While investors may base their decisions on a
diverse set of factors, they are still looking for cause and effect.
The rise of assets allocated to ETFs and the underperformance
of active managers has caused many to claim that ETFs are distorting the market
and creating a bubble. Some claim
that since most ETF assets are passively managed, they must buy all securities
in a benchmark regardless of the underlying fundamentals. Therefore, ETFs lead to stocks with
unattractive fundamentals that are overvalued. Flows into ETFs are said to be causing crowded trades where liquidity
may dry up in the event of a downturn. Many believe that the increasing
popularity of ETFs will lead to the next market crash. Is this criticism warranted?
Everything affects
the market. First, it would be
foolish to say that ETFs are not having any effect on the market. Every trade influences the market, however
minute that influence. Once a trade has
been executed, it is difficult to determine what would have been had that trade
not been executed. ETFs influence the
market just as does the execution of any investment strategy.
Money always flows
into or out of the market. Billions
of dollars are flowing into ETFs. However, to make the case that ETFs are distorting and causing the
overall equity market to become overvalued, you must believe that this money
would not have flowed into equities if ETFs were not available; that investors
were diverting flows from other asset classes into ETFs. However, this money would have most likely
flowed into equities even if ETFs were not available. Consider the graph below which depicts ETF and mutual fund
flows.
The graph to the left (Source: Cirrus Research) indicates large flows of funds into ETFs as well as negative mutual fund flows. It does seem reasonable to presume that ETFs are not stealing money that
would have flowed into other asset classes but rather capturing at least some portion of these flows that would have moved into equities anyway. ETFs have quickly become one of the vehicles of
choice for equity investors. It appears to be a stretch to blame ETFs for high market valuations. Yes, some stocks must be held
by ETFs that active managers might not hold, but, overall market multiples are probably not as dramatically affected
as critics claim.
Equity Universe Shrinkage. Part of the reason for rising equity
multiples is that there are fewer publicly traded companies in the United
States. Following a peak in the mid
1990s, the number of companies listed on U.S. exchanges has declined by almost
50%. A report by JP Morgan noted that the number of companies listed on U.S.
exchanges totaled over 8,000 in 1996. By 2016, that number was 4,333. The
Wilshire 5000, created to capture the broad U.S. market now only has
approximately 3,800 constituents. While
there may be many reasons for this decline, the fact remains that there are
fewer publicly traded companies. As the
number of stocks declines, this pushes more money into a smaller number of
names. The law of supply and demand
dictates that when supply decreases, prices increase.
Low Equity
Correlation. If ETFs were distorting
the market and pushing the prices of all stocks up as claimed, a high level of
correlation among equities would be expected. The intuition is that since ETFs must buy all equities in a benchmark,
those securities should all move together – a rising tide lifts all boats. However, the opposite is happening. The illustration below (Source: Axioma) reflects that correlation
among equities has decreased to very low levels.
News Matters. Equities still appear to be responding to
fundamentals and news. Prices still
react to earnings news. Companies that
exceed (miss) expectations exhibit strong (weak) performance. The chart below (Source: FACTSET) depicts the performance of
SUE – the Standardized Unexpected Earnings – a measure of earning
surprise. The statistic measures the
earnings surprise in terms of standard deviation above or below the consensus
earnings. The chart shows that recent
performance of this measure is above its long-term average and does not look
out of place when compared to its history. Again, this shows that equities are still responding to fundamentals.
Additionally, indications of future earnings, e.g.
product approvals, positive or negative performance of product trials, legal or
regulatory issues, etc., still have an effect on price. A recent report by Cirrus Research reviewed the performance of
the stocks within the S&P Midcap Index with the highest ETF ownership. In these securities, ETFs held 20%-30% of the
shares outstanding. There was a sizeable difference in the performance of these
securities, indicating that news and fundamentals still matter.
Is It Merely Sour
Grapes? Active managers are paid to
outperform the benchmark. In fact, they are paid handsomely to outperform. When they fail to outperform, they must come
up with an explanation as to why they underperformed. ETFs are a convenient culprit, however, the
facts dispute the claim. The chart
below depicts the number of large cap equity managers outperforming the Russell
1000.
The graph ot the left (Source: Jefferies) indicates that managers underperforming their
benchmarks is not unique to the recent period of large ETF flows. Active managers have always had a hard time
outperforming the market – a fact that has given rise to the increase of assets
in passive strategies. In fact, while
core managers are underperforming their benchmark, growth and value managers
are doing well. S&P has also devised
its SPIVA scorecard that measures manager performance. While in certain categories the level of
underperformance is high, it is not unprecedented. There have been similar periods in the past –
periods where ETFs were not as large of a factor – when active managers
exhibited similar underperformance. If
anything, underperformance of active managers is causing the increase in
popularity of passive funds, not vice-versa.
New Products May
Shift Focus Back to Fundamentals. Smart Beta strategies are growing and attracting large flows. While many of these strategies are passive or
mechanical in nature, they are utilizing many of the same fundamental factors
which active managers utilize. For example, they are looking at valuation
measures such as P/E, P/B, dividend yield; measures of quality such as
accruals, ROE, ROA and momentum factors. Additionally, active managers are dipping their toes in the water by
creating ETFs versions of their active strategies. The point is that the next wave of ETFs may
incorporate more fundamental measures of equity valuation.
Ceteris Paribus. This Latin term means “all other things
equal.” In reality, all other things
equal is difficult in practice. It is difficult to look at one thing in
isolation. In evaluating the market, it is difficult to isolate the effect that
ETFs are having on the market. Are ETFs
having an effect on the market? Yes, all
trading and strategies have an effect on the market. Are they responsible for causing a bubble,
distorting the market and making it impossible for active managers to
outperform?The answer is probably
somewhere between these two extremes.
Thank you for reading ETF Global Perspectives!
_____________________________________________________________
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