Market volatility in October, in particular problems with ETF giant Vanguard, served to remind us that market falls will likely be exaggerated by problems with the ETF market.
In July 2017 we said:
“It is typical with investment bubbles that a sensible financial innovation is hijacked, and investors increasingly dis-engage brain.” (33rd edition, TopFunds Guide)
Exchange traded funds (ETFs) are that sensible financial innovation which has been hijacked, those invested into both the stock market and bonds. The 2017 article is extracted below, “Passive Aggressive Investing: Boom, Bubble, Bust”.
Here I want to reflect on how one huge company (Vanguard) couldn’t cope in October, and the latest coded warnings from central banks.
On the most volatile day for markets (10th October), the Vanguard systems failed their normally loyal band of ETF investors. The problem wasn’t just the website but also their app and phone lines. The previous disruptions occurred, you guessed it, with the (moderately) volatile days in February.
According to the FT “many clients were unable to trade”. Vanguard tweeted “keep calm and stay the course”. Perhaps. But that is not the point.
That the infrastructure of the world’s second largest fund group should be disrupted so easily is a concern.
The market volatility was not particularly extreme on either occasion. February was merely a wobble, at least in the headline markets.
Beyond Vanguard’s own infrastructure problems (one of their users said their web site has something of the Zimmer frame about it) the infrastructure of the wider ETF market has still not been tested. Remember, the ETF market is now worth more than $4 trillion, compared to under $1 trillion in 2008.
For example, who will buy from the ETF managers when they need to sell to meet redemptions? The larger ETFs mirroring, say, the S&P 500 index should be fine. But what about those funds invested into inherently illiquid bond markets? Or those focussed on derivatives, where liquidity can dry up in an instant?
In addition, the number of types of ETFs is also now much greater, more complex... and untested in a market moving sharply lower.
For example, there are now around 3.3 million different indices around the world. That’s 76 times more than the number of publicly traded companies: 43,036 (Source: World Federation of Exchanges). Not all of those are tracked by an ETF but growth in the ETF market has been strong: in 2006 there were 713 ETFs. 10 years later that had grown 570% to 4,779.
As new ETFs are launched, new indices need to be created for them to track.
The regulators have been focussed on jazzy ETFs which rely on derivatives (so not invested in what you and I would call real investments - you know, in a company that makes stuff, and might even pay dividends). Though these are small compared to the total ETF market, contagion is a serious problem.
For example, trust and confidence are vital components if markets are to work. ETFs will not trigger market declines – that could be any event, and it is largely pointless spending too much time trying to figure what that might be. But if trust and confidence fail in the ballooning ETF market wider market falls will be exaggerated. When the values of derivatives-based ETFs plummet, or trading is halted in very popular bond-invested ETFs, fear will quickly spread to holders of more liquid ETFs.
Concentration risk is also serious, and arises in two ways. Firstly, the FAANGS feature heavily in the indices which underly passive funds. Apple alone is featured in over 200 indices. This means huge sums of money are flowing into a very small number of stocks. This always happens at serious market tops.
Secondly, there is a heavy concentration of investments in relatively few institutions. In 1990 the 10 largest financial institutions held about 10% of US financial assets. Now that figure is about 80%. If these institutions are forced to sell, who will buy?
There will almost certainly have to be action by central banks to “encourage” institutions to buy, or they might intervene directly to buy. But they will only do so once markets are much lower – this action will only be taken in extremis.
Mark Carney, governor of the Bank of England, recently highlighted the rising risk of a “disorderly reversal” and continued:
“market participants need to be mindful of the risks of diminished market liquidity, asset price discontinuities and contagion across asset markets.”
In plain English he is saying when no one wants to buy, prices will plummet, and there will panic.
For the avoidance of doubt, in case anyone thinks this is simple ETF-bashing, these same liquidity problems prevail with all types of funds invested into bonds, or which rely on derivatives. And we have frequently pointed out that all unit trusts/OEICS also have the right t suspend trading in extremis – on which see our “Opportunity Knocks or Apocalypse Postponed?”
report earlier this year.
I simply focus on the ETF market because of the rush of money into this area, the increasing complexity, the prevalence of less sophisticated investors, the promise of minute to minute liquidity, and buying for cheap fees rather than due to any underlying value. Once market falls take hold selling by ETF investors will drive much sharper falls.
EXTRACT: TopFunds Guide, July 2017
Passive Aggressive Investing: Boom, Bubble, Bust
The human tendency to herd is a key ingredient of a market bubble, combined with greed. In the 1990s technology funds were bought simply because they were going up, and up, and up. People felt stupid if they didn’t invest into them – because all their friends were doing it. As Kindleberger put it:
“There is nothing so disturbing to one’s wellbeing and judgement than to see a friend get rich”
The tendency to herd was encouraged by mass marketing of such funds, and a largely quiescent media. What about now? The behaviour of investors buying passive funds, particularly exchange traded funds (ETFs), are increasingly marking out 2017 as the euphoric stage in a bull market which began in 2009.
“Mass escape from reality”... ...as JK Galbraith put it. 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, and it now dominates the US stock market e.g. ETFs are now responsible for 50% of daily trading.
In every edition of the TopFunds Guide 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.
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)
The essential irrationality
We know that low interest rates and/or easy credit are typical components of bubbles. Some sensible innovation (it might be technology or a financial product) becomes the target for irrational speculation, fuelled by cheap money. Irrationality is the essential element to distinguish this as a bubble rather than a mere boom.
What is the evidence for irrational buying of ETFs?
Firstly, the focus on the low charges of the product itself rather than the extraordinary over-valuation of the underlying holdings. As an FT editorial put it: “passive investors have come to falsely equate low fees... and a rising market with low risk”.
To repeat - you are buying cheaply what has never been more expensive (but for 1999, the pinnacle of the biggest bubble in 300 years).
Then there is the manic buying and selling despite well-established research highlighting that regular buying and selling results in poor performance (confirmed by the Dalbar Study). By its nature you tend to be buying individual shares which are getting more expensive, and ignoring those which are good value. In fact the shares in the index are only getting more expensive because of the ETF investors who are only buying because ETFs are cheap!
Nor do ETF investors discriminate within sectors. Do you really want to buy every banking stock? Are you sure?
More expensive. No discrimination.
No attempt to identify quality.
No underlying measure of value.
This is the antithesis of rational investing. If this type of irrational investing and behaviour also dominates the day to day trading in the stock market would you not think it fair to define the market as being in the midst of a mania? Definitely.
This is the euphoria phase - this is an investment bubble.
What next? Sadly, identifying a bubble does not inform you as to when it might burst - it could be a year or two away. But you can already guess how it might unfold.
When the ETF investors discover their folly and sprint for the exit (as the FT put it with surprising candour) “selling would be indiscriminate and self-reinforcing”. Some ETF prices will fall more sharply than the index because they cannot keep up with the stampede to sell - others will suspend trading and create an even bigger wall of determined sellers, in turn more and more fearful.
Be wary of those peddling the merits of passive investing, even if it’s Jack Bogle. Passive investing is at the heart of the third investment bubble in less than two decades. Passive investing on this scale is aggressive and irrational. It carries great danger for markets as a whole, equities and bonds.