ETF Folklore

“From the industry perspective, what’s brilliant about ETFs are they have the ability to work well under pressure. Any time we’ve seen dips or a bear market, we’ve seen ETFs be a good haven because all you’re doing is going to a different side of a trade.” – Global Asset Manager with >$1T AUM

The appeal of ETFs to investors is diversification. The ETF surge represents a shifting investment ecosystem away from active, toward passive. According to a Charles Schwab 2017 ETF Investor Survey, the percentage of ETF investors by demographic is as follows: 56% of Millennials, 44% of Gen X and 30% of Boomers. In fact, an astounding 96% of millennials see ETFs as a necessary part of their investment strategy, perhaps because they have less money available to invest.

ETFs are appealing because:

• They have lower expense ratios
• You can purchase fractional shares
• They are more attractive for people with little knowledge
• Typically there’s no minimum to invest

Crunch Time

However, many ETF investors are unaware of the risks of investing in ETFs. Some [watchdogs] see an ETF bubble that is set to burst, even though what is being invested in is more of an investment wrapper than an asset class in its own right.

Our current financial system is geared towards a much lower average life expectancy. Yet, as people live longer, their portfolios need more durability. So what is the liquidity of ETFs and the ability for ETF companies to unwind when, for example, a boomer needs to start drawing down? Or, what happens during a crunch?

Facing Liquidity

“I’m not worried about ETF liquidity. There’s always the fear of that but I don’t think there’s suddenly going to be a liquidity drought in asset classes. It’s really at the very back of our heads.” – Large Pension Fund

High-frequency traders, traditional active fund managers, and other value investors believe that one of the challenges for ETF companies will be unwinding their positions. For some financial institutions that own ETF providers, exiting subscale market positions may prove to be attractive. The rapid growth of the ETF market means that we’ve seen comparatively few exits. In a consolidating market, ready buyers could be plentiful. But the challenging economics of ETFs could mean that sellers find exit valuations disappointing.

Mistaken Valuation

Cash inflows to an ETF that has large holdings of a specific company could misprice a company blindly. “In the largest products, where most of the money sits, about 90% of trading that occurs is in the secondary market, according to Vanguard’s research. That means ETF investors are passing investments between themselves, and not having to transact with fund managers.”

Another reason for concern, a July report from Cirrus Research cites that, “companies with higher ETF exposure have steadily underperformed their counterparts since last June.” While the rise of robo advisors reflects this changing paradigm, a lack of understanding drives ETF demand and introduces risks. And it shows no signs of slowing down with 61% of millennials planning to increase their ETF positions. So while wealth managers used to be too expensive for the masses, automation is changing that and ETFs are democratizing the investment world.

ETFs played a role in the sell-off in 2015:

• According to SEC, exchange-traded products experienced higher volume and volatility than standard stocks
• Swings in price seemed arbitrary among otherwise similar ETFs
• Many of the shares owned by investors were dealt by short sellers (unbeknownst to the investors)
• As investors realize they own ‘synthetic’ ETF shares, the situation could explode

Before the Burst

Banks and trading firms happily sell and trade ETFs when the market is calm. When they can buy at a discount and sell at a premium, these firms will continue to offer ETFs in large quantity. But when that is no longer a probability or possibility, the suppliers of ETFs will most likely disappear, essentially undoing the entire system. But there are ways to fix the bubble.

‘Physical’ ETFs have much lower risk because they are actually hard backed by the underlying security. Diversifying with equities that aren’t usually tracked by ETFs can help avoid market cap bias.

How Close is the Burst?

Millennials are pouring their investment dollars into ETFs. They’re also the target of many of the robo advisors and FinTech’s helping investors begin to grow their wealth. Many of these robos and “set-it-and-forget-it” FinTechs are leveraging ETFs in their portfolios due to the lower price point, dollar-based investing, etc.

That said, could the potential burst or liquidity crunch be stalled due to the influx of Millennials investing in ETFs? Or is that a temporary distraction? Will the robos and FInTechs potentially suffer the same fate?

Case in point: look what happened to some of the robos that got squeezed during Brexit as people demanded access to their funds. Will this instance be a case of only time will tell or are these brakes on their potential roller coaster?   

What do you think?

^{1, 2} Citibank “New Approaches to Active Management & The Need for Manufacturing Flexibility in an Era of Asset Class & Factor Investing” 2016
³ Financial Times
⁴ Bloomberg