David Jane, manager of Miton’s multi-asset fund range, says that the rising popularity of exchange-traded funds is based on flawed logic. He explains some of the risks of using trackers.
The past few weeks have seen a number of headlines about the growth of exchange-traded funds (ETFs) and index investing in general.
ETFs, particularly in the US, have come to dominate retail flows, while investors have been takin money out of active funds.
It is presumed by the theorists that ETFs have a broadly neutral impact on share prices and that ‘price discovery’ will continue despite the ever-dwindling ranks of active managers, but we do not think this is the case, as ETF flows are not equal across all stocks.
Some stocks are in multiple indices and, therefore, attract flows from multiple sources, whereas many stocks appear in very few. Combine this with the rise of ‘smart beta’ investing and specialist ETFs, and you get a very imbalanced flow from the ETF buyer.
An additional factor is the simple fact that the freely available shares of certain stocks is much less than others and you can see that ‘passive’ investing is anything but; it leads investors to place increasingly disproportionate amounts of capital within an ever-narrower universe. Finally, the theory supposes that ETF buyers are not a herd, chasing the same fashions and trends, when clearly they are.
An additional feature is the rise of various forms of ‘advanced’ or ‘smart beta’ asset management, a particular favourite of mine being ‘risk parity’ strategies. These aim to optimise returns by combining equities and bonds, so nothing new there. Bonds are expected to do well in weak economies, when equities might be doing badly. However, recognising that bonds are less volatile than equities, the amount of bonds required to offset falls in equities in bear markets makes the suggested mix unattractive from a returns point of view.
The solution: gear up on the bonds such that they match the volatility of the equities, so that their return is sufficient to offset equity market falls in times of economic weakness. Of course, the past returns look spectacular, 30 years of rising bonds and equities, with the occasional set-back for equities coinciding with strong rises in bond prices: what’s not to like? #
Like all seemingly clever answers to the question of how to manage the uncertainty of investing, there is a flaw; in this case, many. The principle flaw in the risk parity argument is to presume that risk means volatility and that volatility implies a return. The logic behind this is that investors expect a return in exchange for experiencing volatility. Therefore, the higher the volatility, the higher the return.
Like so many arguments that seem quite logical in a textbook, in practice this is utter nonsense. A very brief observation of the real world will show that there are plenty of assets which are volatile but offer no expected return – currencies quickly spring to mind – while at the same time there are plenty of seemingly low volatility assets with relatively high risk – property for example, whose low volatility is a consequence of illiquidity.
This obvious flaw in the logic might be surmountable were it not for two other major failures of the approach. Firstly, the presumption that the only risk that needs to be addressed being the economic cycle, or more nuanced, changes in the market’s opinion on the cycle.
It doesn’t take more than a few moments of consideration to recognise that changes in equity and bond prices, particularly in the post-QE era, are also driven by other influences, and therefore it is entirely reasonable to expect that the presumed relationship that bonds rise when equities fall is a nice presumption but may not always hold.
In fact, very recently the taper tantrum evidences that relationship certainly does not always hold and a view on longer term history shows that periods of negative real returns from bonds are as likely to be associated with negative real returns on equity as not.
Some risk parity strategies attempt to address this by introducing index-linked bonds to cover off a further driver of equity and bond prices, when inflation expectations are rising it may be poor for your bonds and equities but the index linked should kick in.
Which brings us to the final flaw in the thesis: basically, markets do not do what they are supposed to do, they do what market participants in aggregate make them do. So, while the approach may seem logical on paper, unless we take into account the actions of market players in the past and, therefore, the starting point for valuations, we can’t determine what asset prices might do in the future. In simple terms, prices matter.
While buying bonds at negative real yield may seem logical to someone who believes past relationships hold and theory is all that matters, that is to ignore the simple fact that, whatever the theory may say, a negative real yield is a negative real yield, therefore you will definitely get a negative real return if you hold the bond until it matures.
Of course, like pretty much all financial market theory, the risk parity magicians ignore the impact of their and others actions in distorting prices. So, the worthy efforts of pension funds and others to reduce their risk have had the unintended consequence of leading them to eliminate their return, and potentially to lead them to long term negative absolute and real returns. Those that use gearing will have a highly geared yet loss making position.
So where do indices and ETFs fit into this picture? In a sense, the whole trend is based on the same flawed logic. The ETF bubble is based, like risk parity and other theory based asset allocation strategies, on flawed logic.
It could simply be seen as a ‘tragedy of the commons’. In economics this is where self-interested individuals deplete a shared resource in their own self-interest but ultimately destroy the resource through their collective action.
The same is the case for ETFs and smart beta. At first, index fund buyers can take advantage of the price setting actions of active investors for free and risk parity managers can take advantage of leverage to capture high real returns from bonds. At some point, the ETFs and smart beta strategies are setting prices despite being ‘price insensitive’. Eventually, they each drive valuations to levels where the opportunity no longer exists, however, the momentum driven by past success leads the fashion to continue until ultimately things go wrong.
Have we reached that point? Only time will tell, and as genuinely active investors, we will have to deal with that scenario when it comes. Rather than relying on some seemingly simple answers, we will fall back on pragmatism and common sense to deal with each situation we face.
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