Cause and Effect

Thursday, December 7, 2017 - the below is a contributed post by Dan Carlucci, member of the ETF Global Research Advisory Board

“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.

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