Klarman: ETFs Are Dangerous But A Boon To Value Investors

Wall Street has seen its fair share of controversial investments throughout its history, but one of most controversial, yet popular products has to be the ETF.

Despite numerous warnings from some of the world’s most renowned investors, ETFs continue to attract record levels of investor cash. Last year, investors added a total of $282 billion to ETFs, a record figure, surpassing the previous annual all-time high of $244 billion set in 2014.

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As investors gobbled up ETFs last year, they were simultaneously dumping mutual funds. For example, in the week after Donald Trump’s election, investors flooded $27 billion into equity ETFs according to Lipper and EPFR fund flow data. However, during the same period, a U.S.-based equity mutual funds posted $3.4 billion of outflows.

Klarman: ETFs Are Dangerous But Should Help Value Investors

It remains a mystery why ETFs continue to attract such massive quantities of cash when so many high-profile investment figures have warned against the use of the product. The latest investing figurehead to warn against the dangers of ETFs is Seth Klarman, who devoted a portion of his year-end 2016 letter to the subject.

Klarman has pulled together the shocking figures of the ETF industry. He writes that at mid-year, 11.6% the S&P 500 was held by index funds and index ETFs, up from 4.6% a decade ago. A total of $3.2 trillion in assets is now deployed in such funds. He goes on to write that over the past 12 months US ETFs have attracted $240 billion (at odds with the figure above from ETF.com) while $131 billion has flowed out of US mutual funds.

ETFs are generally considered to be passive products but based on trading data they are anything but. Indeed, according to John Bogle, founder and retired CEO of Vanguard, the average turnover for an ETF is 880% per annum, compared to just 12% for a standard stock. Five of the world’s seven most heavily traded equity securities and now ETFs.

The issue with ETFs is that they’re often tracking illiquid instruments, and the mismatch between the liquid ETF and illiquid underlying security will result in market dislocations.

The issue with ETFs is that they’re often tracking illiquid instruments, and the mismatch between the liquid ETF and illiquid underlying security will result in market dislocations. Per the Financial Times, “because the securities they hold are often not as liquid as the ETF itself, there are risks of mismatches and forced sales.” The concern is that such market dislocations will increase volatility and market shocks. As of yet, and ETF inspired a market crash has not yet emerged because they are still too small as a percentage of the overall market. According to Amin Rajan, head of Create Research in the UK, “by themselves, ETFs do not as yet have the critical mass to kick-start a systemic crisis…But they do have the ingredients to create a snowball effect, once markets go south decisively.”

Klarman goes on to write in the year-end letter that ETF activity tends to “lock in” relative valuations between securities as managers have to buy securities in an index in proportion to their current market capitalization. Therefore, high valuations are likely to persist. Klarman goes on to speculate that with the money being concentrated in indices, those equities outside the indices may fall out of the range of investors, increasing the likelihood of security mispricing and giving long-term value investors a distinct advantage. Ironically, this means that as more and more people buy into the efficient market theory and shun active management, the more inefficient the market is likely to become.