Passive funds, also called exchange-traded funds (ETFs), have been gaining popularity over the last few years, as their fees are much cheaper than those of active funds, and active fund managers often fail to beat the index.
But more recently, they have been criticised for pushing valuations higher and creating a bubble, while also facing liquidity risks and potentially not being able to cope with a market crash.
One such critic is Clive Hale, director of FundCalibre. He argues that the extraordinary valuations of the US stock market – which are three times their 2009 low – are driven by ETF buying, as passive funds now account for a third of the US market.
Hale says: ‘This ETF “fad” is something of a self-fulfilling prophecy and there are inherent dangers. The more ETF buyers the more the stocks comprising the index are bought by the ETF managers. As indices are generally market weighted, the largest stocks get bought the most and, given their weighting, the index rises as a result. More and more money is flowing into fewer and fewer stocks.’
According to Hale as stocks become more and more expensive the ETF managers’ hands are tied as they are essentially forced buyers.
He argues that this will come to a bad end: ‘When it is seen that the emperor has no clothes and the selling starts, the index and the top weighted stocks will fall as fast as the they have risen.’ He says market falls could be significant. ‘ETF managers believe that liquidity is not an issue, as they are investing in large cap stocks. When everyone heads for the door, that notion will be dispelled.’
Not everyone, however, shares these concerns. Oliver Smith, portfolio manager at IG, instead argues that the large ETF trading volumes in themselves are of little consequence, as the majority is due to buyers and sellers exchanging their holdings with the end result being that there is little-to-no impact on the market.
‘This is because ETF shares are not physically created and redeemed in anything like the volume that their turnover suggests. Using Bloomberg daily data we calculated that in July 2017 the $240 billion SPDR S&P 500 ETF had total turnover of $281 billion, but only $16.9 billion of shares were created and redeemed over the entire month (the net increase in shares outstanding was of 12.3 million shares, or $3.03 billion).’
Further, he criticises the assumption that ETF investors will get a shock when markets fall, and active management will outperform. ‘The theory behind this is that because index funds replicate the index, they have too much exposure to highly valued stocks and will underperform active managers once sentiment turns negative.
‘The problem with this idea is that, in aggregate, active managers are the market. For every manager that is underweight Vodafone, there is someone else who is overweight. There is little evidence that active funds systematically outperform in a market correction, as they still have the hurdle of fees and trading costs to overcome.’
In addition to that, there are ETFs with various strategies, such as equal weighted holdings, value and size tilts, or minimum volatility, so-called smart beta funds. ‘These strategies have encroached further into the territory of actively managed funds, and do perform very differently from traditional market cap indices giving investors plenty of choice.’
On the question of liquidity, he counters that actively managed funds face the biggest liquidity threat. ‘This is because securities which are held in indices have a much larger audience - both mainstream and also held in size by ETF market makers. ‘In times of crisis, it is the holdings which are ‘off-index’ which can literally have no bids for them when there is a forced seller and liquidity dries up. This causes prices to gap down by a large amount, and is one of the reasons that small caps always perform worse than large caps in a sustained sell-off.’
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