Over the last few years, as nervous investors worried about a market that has risen to record highs on trillions in central bank liquidity, and seeking some particular market product to which they could transfer their concerns and fears, ETFs quickly emerged as the current generations' "CDO" - the product that will accelerate the next crash when the BTFD mentality that has defined the market for the past 8 years, finally ends as central bankers pull the rug from under an entire generation of traders.
Two months ago, Arik Ahitov and Dennis Bryan, who run the $789 million FPA Capital fund, took the subconscious fears about ETFs to the next level, when in taking a page out of the Warren Buffett warning books, the duo said that Exchange-traded funds are “weapons of mass destruction” that have distorted stock prices and created the potential for a market selloff.
In an April letter the two warned that "when the world decides that there is no need for fundamental research and investors can just blindly purchase index funds and ETFs without any regard to valuation, we say the time to be fearful is now." They also noted a previously voiced warning that that "the flood of money into passive products is making stock prices move in lockstep and creating markets increasingly divorced from underlying fundamentals" and that "as the market moves ever higher, there’s the potential for a sharp decline."
“This new market structure hasn’t been tested,” Bryan said, noting that the stock market has never gone through a major downturn when passive investors were as important as they are now. “We could get an onslaught of selling.”
The simplest summary of the latent worries about ETFs is that i) they provide phantom liquidity: there when not needed and gone when needed, and ii) as a result of wholesale capital flows, they misprice risk among bulk asset classes, so when selloffs occur, the most liquid underlying stocks - usually the most attractive ones - are hit the most.
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Fast forward to today, when the torch of worries about ETFs was picked up by none other than Bank of America's Savita Subramanian, who published a research report titled "The ETF-ization of the S&P 500", in which she warns that higher single-stock volatility, valuation distortions and liquidity concerns could grow due to the surge in popularity of ETFs, which now account for more than a third of U.S. ownership of the S&P 500.
As Subramanian writes, "historically, large cap US equity managers have had the luxury — and curse — of a liquid, efficient market. On the one hand, capacity has been less of an issue for the S&P 500 than it has been for the Russell 2000, but on the other hand, it is much harder to have an edge on large, well-followed stocks than on smaller, less-followed peers."
And, as the bank warns, "that liquidity is slowly being called into question by the “ETF-ization” of the S&P 500. US trading volume today is now 24% exchange traded funds (ETFs) and 76% single stocks versus 20% ETFs and 80% single stocks three years ago."
Furthermore, BofA, which echoes Howard Marks 2015 warning that the S&P is not as liquid as it seems, calculates that the proportion of stocks in the S&P now managed passively has nearly doubled since the 2008 crisis to 37 percent while ETF trading accounts for about a quarter of the daily volume across U.S. exchanges.
Just as concerning, the percentage of S&P 500 market cap held by Vanguard alone has doubled since 2010, to 6.8% today. Vanguard currently is a 5%+ shareholder of 491 stocks in the S&P 500, up from just 116 in 2010.
While hardly a surprise, BofA notes that equity client flow data similarly suggests that investors have increasingly shifted to passive investments: clients have been net buyers of over $160bn in ETFs vs. net sellers of over $200bn in single stocks since 2009, and the bank's Global Wealth & Investment Management clients’ equity and debt ETF allocations have risen to nearly 12% and 10%, respectively, today, from less than 2% in 2005.
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Looking at the potential liquidity implications, BofA also warns that the actual shares available, or “true float” (float shares less shares held by passive funds) for S&P 500 stocks, may be grossly overestimated, and concludes that as these structural changes play out in the market, there are vast implications for US investors.
The next question BofA tackles is how much further this active to passive rotation can go before markets become dysfunctional. It points out In Japan, nearly 70% of the assets under management (AUM) ofJapan-focused equity funds is passive (granted, the BoJ has been buying ETFs) and their markets are still functioning.
This is almost double the proportion of US passive. although the victim in Japan - as is increasingly the case in the US - have been active equity managers.
Japan’s case, the casualties may be the active equity business, where active managers have suffered outperformance rates 12ppt lower over the last three years of accelerating passive inflows vs. over the prior decade (34% of funds outperforming the TOPIX between 2014-2016 vs. 46% outperforming between 2002-2013).
So, as the ETF-ization of US stocks is likely to continue, BofA highlights what it believes as four critical warnings implications as increasingly more market decisions end up in robotic, quant, algo and other non-human hands. From BofA:
1. Avoid crowded stocks (especially right now)
Over the short-term, our work suggests that positioning matters more than fundamentals: buying stocks which are the most underweight by large cap active managers has led to stronger three-month returns than investing in Low P/E stocks or stocks with favorable growth or ROE (Chart 7). Crowded stocks have generally underperformed neglected stocks in recent years as mutual funds are net sellers and passive funds are net buyers. Crowding risk is particularly acute at quarter-end when allocators tend to rebalance: in the first 15 days of the quarter, positioning alpha is 10x higher than average (Table 1).
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2. ETF fads can drive massive PE distortions
ETF trends can dramatically distort multiples: with the meteoric rise in Low Vol ETFs (150% annual asset growth since 2009) low beta stocks saw a >200% surge in relative valuations to never-before-seen premia. Where to spot this next? Our work suggests that the next influx may be into Value ETF strategies, ESG strategies and other quant funds.
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3. Know your risk: a screen for stocks with low “true float”
If passive funds own a large percentage of stocks and will only buy and sell based on changes in market capitalization or other metrics, the actual float of a stock may be far lower than we think. Our analysis of stocks most held by passive funds suggests that the volatility of stocks (measured by both standard deviation and price declines) with a larger proportion of shares held by passive investors has systematically increased, as the market begins to appreciate the fact that the actual liquidity profile is overestimated. In fact, excess price volatility of stocks with low “true float” (i.e. those with a high proportion of float held by passive) tripled in the last twelve months.
But the multiples of stocks with lower “true” float may not be fully reflecting this risk. As their volatility profiles have increased, stocks with low “true float” have seen some multiple compression, but still trade in line with their more liquid peers, where in our view a discount might be warranted.
Moreover, their peak to trough price declines are significantly deeper, further corroborating their impaired relative liquidity.
4. Time horizon arbitrage
Our analysis shows that fundamental signals have significantly improved in efficacy over longer time horizons, whereas algorithm-driven signals perform well in the short term, but the decay rate is extreme (Chart 12-Chart 13).
Valuations explain almost 90% of the S&P 500’s returns variability over a ten-year time horizon (Chart 14) – we have yet to find any signal with even close to that level of predictive power over the short-term.
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Which brings us to BofA's striking punchline: between central banks, quants, and ETFs, the market is becoming increasingly inefficient:
... ironically, what should be an increasingly efficient market has shown signs of becoming less efficient over the long term - alpha opportunities, measured by the range of market prices, have shrunk on a short-term basis...
... Just as we said would happen back in 2009.