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Boom Bubble Bust: Part II - The ETF Mania

Posted by: Brian Dennehy

 
Last week, in part 1, we looked at past bubbles, and noted that a key ingredient in this euphoric stage is some form of extreme, irrational, investment behaviour.  Is there such evidence now?
 
Is there a “mass escape from reality”, as JK Galbraith put it?
 
Our view is that the behaviour of investors buying passive funds, particularly exchange traded funds (ETFs), are increasingly marking out 2017 as the euphoric, bubble, stage in a bull market which began in 2009.  Let’s explore that.
 
ETFs – a sensible innovation
 
Index tracking funds precisely mirror the ups and downs of the stock market, less fund charges.  There is no active fund manager input, so to contrast them with actively managed funds they are called passive funds.
 
These passive funds are of two main types.  The oldest type are unit trusts (or OEICS), with roots back to the 1970s.  Then along came exchange traded funds (ETFs) in the 1990s.  
 
The ETF trackers advantage over equivalent unit trusts is that they allow intra-day trading.
In contrast if you sell a unit trust tracker the price is fixed at the end of each day, and you find out your selling price the next day.  
 
We like this about ETFs – they’re a useful tool in our armoury for advised clients.  So far so clear and uncontroversial.
 
Now a passive aggressive mania
 
It is typical with investment bubbles that a sensible financial innovation is hijacked, and investors increasingly dis-engage brain.  Herding and greed become prevalent.  
 
Jack Bogle was founder of Vanguard and the passive fund industry in the 1970s.  He always lauded the superiority of old-style index trackers (of course he would) but now warns of the dangers of equivalent ETFs.  
 
Passive funds – ownership and behaviour
 
Jack tells us that “individual investors are by far the largest holders of Vanguard’s old-style index trackers, and that the turnover of these funds is just 8% per annum”.  For every 100 of his investors, only 8 will sell in any one year.
 
In contrast, the largest ETF tracking the US stock market (SPDR 500) is 90% held by banks and financial intermediaries.  According to Jack the annual turnover is around 3,000%, translating to a holding period of roughly 12 days – wow.  
 
That has nothing to do with investing – rather it is out and out speculation.
 
In every edition of the TopFunds Guide (page 20) we clearly state that we (that’s all of us) are not naturally good investors.  And the vast majority are bad investors in practice too. 
 
Those unhelpful animal spirits come to the fore when motivated by greed and the instinct to herd e.g. the bull market in US equities is very long in the tooth, but rather than serve as a warning (in what other field do you become more inclined to buy when prices go up?) it engenders complacency.
 
This complacency is even greater if you are an expert (e.g. the majority of ETF investors).  You might think experience and expertise would make you wary where mere mortals are gung-ho – not a bit of it.
 
Bad Timing
 
The annual Dalbar Study in the US considers how much money investors lose through bad timing.  For example, the 2017 study tells us that if investors had simply bought and held the S&P 500 over the last 15 years they would have gained 4.98% per annum – but in practice passive investors (those invested in index trackers) only made 2.85%.   
 
Why?  Because with ETFs you can switch in and out of these trackers several times a day if you wish.
 
“The easier it is for us to time the market, the more we take advantage of the opportunity to time it badly” (FT).  Indeed.
 
But is the ETF buying irrational?  And even if it is, is there scale to this behaviour which marks it out as a market bubble rather than just bizarre action at the margin?  That’s our focus next week in Part 3.

Topic: Market commentary


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