Looking for the Next Bus: ETFs and Passive Investing

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Jun 28, 2017 2:22:06 PM

and tagged Investing

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passive investingIt’s never the bus you’re watching for that hits you, they say. Even if you are watching for different buses, sometimes it pays to look at just how close they are getting to you. In that spirit, and in response to some questions I have gotten recently, let’s look at two different buses that could run over the markets: exchange-traded funds (ETFs) and passive investing.

What’s so bad about ETFs?

The argument against ETFs is that since they act as wrappers for the securities held within them, and since they trade actively, a collapse in the markets for those underlying securities could cause the ETFs themselves to collapse. Alternatively, a collapse in the ETFs could crater the values of the underlying holdings. One worry is that an ETF could trigger a flash crash. Imagine someone dumping a large order of, say, the S&P 500 ETF, selling large amounts of 500 stocks in just one trade. Surely, that could disrupt markets?

In theory, in a small and illiquid security, it could. By definition, though, small and illiquid markets don’t impose large-scale risks. With the S&P 500 example above, there would likely be multiple traders eager to take the other side and profit from any mispricing. We, in fact, saw this occur both in the original flash crash and in the overnight market pullback after the Trump election. Market mispricings tend not to last long, regardless of where they originate.

Even in legitimate market drops, blaming an ETF for a certain sector’s decline is to misperceive what is actually happening. A drop in the value of the underlying securities will be reflected in the ETF’s price, but it is not the cause of the change in price. A big spread between bid and ask is simply a reflection of a market disconnection regarding the appropriate price of the underlying securities, rather than anything specific to the ETF structure.

Because ETFs are wrappers, you get the same opportunities—and problems—with them that you would get with the underlying investments. In this, they are most like mutual funds, another form of wrapper. ETFs also have characteristics of stocks, though, and thus come with the same problems—and opportunities. There are certainly things to be cautious of when it comes to the structure of certain ETFs, but these funds are really just one more way to invest, not some uniquely dangerous time bomb. In earlier market crises, in fact, ETFs have tended to do exactly what they were supposed to do—provide performance similar to the underlying securities they hold.

Passive investing—a more concerning trend

A related topic, and a more concerning one, is the rise of passive investing, which has accompanied the rise of ETFs and benefited from it. With passive investing, you buy a fund that mirrors the index—whatever that is—without making any determination about the value of the various securities inside it. The problem here is immediately apparent: when you buy the fund, without looking at the prices inside, you have no idea whether the index is at an appropriate level or not.

As ETFs make it easy to buy and sell an index as a whole, this potential disconnection between price and fundamentals (i.e., earnings projections, company management, P/E ratios) can make it easier for investors to buy without regard to value. And when value collapses, it can rattle the market. Note, though, that ETFs are an enabling technology and not the root of the actual problem, which existed even before ETFs did. The underlying problem is—potentially—passive investing. We will discuss that more tomorrow.

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