Investing in an ETF DOminated World

We appear to be entering a new age of investing. There is a shift in philosophy away from actively investing in individual companies to passively investing in baskets of diverse companies. The emergence of Exchange Traded Funds has provided a low cost vehicle to enable investors to gain exposure to baskets of companies that track returns of prominent financial indexes.

This shift is clearly happening. In the first 10 months of 2014, US funds run by stock pickers saw withdrawals of $5.7 billion. At the same time $201 BILLION was placed into ETF based products during the same period.

There’s been enough empirical evidence showing that passive index oriented portfolios outperform actively managed portfolios. For posterity, we’ll pull one up from the S&P Dow Jones Indices vs. Active Funds (SPIVA) Canada Scorecard:

  • 89.7% of Canadian actively managed funds failed to match or outperform their respective indexes
  • 94.4% of U.S. actively managed funds failed to match or outperform their respective indexes
  • 88.9% of International actively managed funds failed to match or outperform their respective indexes

Intuitively it seems to make sense. Cheap diversification ensures you will get a piece of the winnings when the market moves up.

Currently, 25-30 percent of trade volume on the New York Stock Exchange comes from the trading of ETF’s. If this change in fund flows into ETF’s continues and with the proliferation of the robo-advisor, algorithm, technology based investing, we could be investing in a world where a significant majority of trades will revolve around index based products. Buying and selling individual companies, would be relegated to a niche business like trading soy beans.

The question that comes to my mind is whether this is a good thing? What will investing and capitalism look like in an ETF dominated world?

I decided to take a shot and try to mind map or mind-word the implications of this paradigm shift. The first thing is to understand what the stock market is all about.

The Traditional Stock Market

A Michael Jordan rookie card is considered one of the great blue chip sports cards out there. Same with the Ken Griffey Jr from the 1989 Upper Deck set

A Michael Jordan rookie card is considered one of the great blue chip sports cards out there. Same with the Ken Griffey Jr from the 1989 Upper Deck set

Visually, the best comparison I can think to describe a traditional stock market, is that it is like a market for buying and selling sports cards. When you are investing in individual stocks, you are in a way collecting individual hockey or baseball cards of your favourite or popular players. Either they are very good and will become in more demand or you think they are an up and coming superstar who will become popular in the future.

An ETF is a lot like buying an entire set of sports cards like this hockey set from 1985

An ETF is a lot like buying an entire set of sports cards like this hockey set from 1985

A Stock Market of ETF's

Every year or in this case season, sports card companies will introduce new sets of cards. Taking baseball as an example, a company will release a set containing all the players in the Major Leagues that will likely be playing in the upcoming season. A set can be sold in one package containing all the cards in the set or they can be sold in packs that allow you the challenge of building a set or collecting and trading more cards of a specific player. To me ETF’s are like buying an entire set of cards. You are assured of getting all the best players and the value of the set will be driven by the quality of the entire contents of the set and not necessarily by individual players. With some exceptions, a set is likely to have lower value than specific popular cards in that set. Like ETF’s, a set of hockey cards will contain not just the best performing players but also the one’s that ride the bench. So like ETF’s to get the best player cards, you have to be OK with holding on to the duds.

Like investing, you have  two options for collecting sports cards. You can collect just the high quality players and collect a lot of them, or you can collect the whole set which will include the superstars but you also have to carry along a bunch of spares.

Role of Stock Market: Price Discovery = Value

One of the main functions of stock markets it to provide a transparent means of price discovery through the trading of individual stocks. The individual trading of stocks, establishes a price that establishes what the market perceives as its current value. Orders to buy and sell are made on stocks based on what the future earnings and cashflow of the stock will be.  Bringing back our sports cards analogy, if more people start buying entire sets of hockey cards instead of buying individual cards, I’m thinking wouldn’t that alter the accuracy of price discovery of the individual cards? If that were to happen, I think that could have serious ramifications on how stocks are priced and subsequently how capital is allocated. 

50/50 Rule

From my research work I did in the past, I discovered that essentially in a typical index, half of the companies are profitable wealth creating companies, while the other half would be considered wealth destroying companies.  This 50/50 ratio would deviate 5-10 percent each way in a typical year. If investors were to use ETF’s solely to diversify their capital allocations across a whole market, wouldn’t that create distortions of each of the individual companies in the index?

At the end of the day, it’s about managing risk. The reality is that ETF’s provide a natural exposure to market risk instead of individual company risks. Intuitively this makes sense to diversify portfolio risk. However I also think, by generating more volume exclusively on market risk oriented transactions versus individual oriented transactions, I would think that spreading that risk out would make price discovery and ultimately the valuations of those individual assets more difficult.

Potential Problems With an ETF Dominated Stock Market

I could think of a couple of ways this could be problematic. One area is through financing activities such as raising capital in the equity market.  If price discovery is marginalized in an ETF oriented stock market, it would make it difficult for a company to establish its valuation to enable the appropriate capital allocations. There’s a big difference in valuing a company when you compare it other similar companies in similar industries, with similar risk profiles versus comparing it to an overall market. You could still do it. Anything can have value put on it, but it is less transparent.

A second area again comes down to valuation. If the oil and gas companies are not creating meaningful profits, should a high-tech sector have to be punished for another section of the stock market’s fallacies? Finally, instead of individual company events impacting the stock price, macro-economic events will drive overall market indexes.

Would an ETF dominated stock market redistribute risk?

As mentioned it all comes down to managing and spreading out the risk. One of the big reasons the US real estate market crashed was that Wall Street attempted to transfer the risk on mortgages, specifically subprime mortgages from the local and individual level to a higher level via the practice of bundling high risk mortgages and selling them to the mass market. ETF’s are really not that much different conceptually, especially if it becomes a dominant form of trading and price discovery. If we move to a world where local company risk is substituted for overall market risk, couldn’t we see the same issues develop in ETF’s, especially ETF’s that don’t have a lot of liquidity behind it?

Implications for our capitalist society

I have no idea if these elements would manifest itself but I came out of this mental somersault with a greater concern about this trend and the potential implications for how we are allocating our hard earned assets. Capitalism is about making decisions to allocate scarce capital resources to activities that will create products and services that society needs. I wonder if an ETF-oriented investment world encourages more socialist form of investing where all stocks within an index share in economic output regardless of their individual performance.  If we continue to adopt capital allocation decisions based on evaluating risk and price discovery by using ETF’s to look at the forest instead of the trees, are we setting ourselves up in the future for a major disconnect in capital allocation and ultimately the valuation of capital? If so, then that will not bode well for our capitalist society. As much as ETF’s encourage more participation in the overall stock market, it shouldn’t increase solely for accessibility reasons. There needs to be appropriate rewards that reflect the risk profile associated with the assets within the index. Joshua Brown expressed this in one of his blog postings, “…a healthy market environment needs good active management and a lot of managers doing well. It’s part of what makes markets function…”