Investors are pouring cash into discount beta vehicles faster than at any time in history, with the industry on course to take a record $385 billion this year, bringing its total assets to $3.8 trillion (£2.89 trillion), according to data provider ETF.com.
While the rapid move out of dearer active alpha-seeking management suggests many investors think the price is right for beta, there are valid reasons to ask whether investors are aware of the idiosyncratic risk they may be assuming, however.
‘Almost by definition it’s trading, not investing,’ argued Charles Plowden, co-manager of Monks Investment Trust, who by definition has a conflict on the issue, but nonetheless offered a clear-eyed critique.
‘Our description of investing is the careful and long term ownership of value creating businesses, and then living off of their cash flow and dividends for the next 30 years. So the selection and time period are vital for that, whereas a passive investor doesn’t know what is in the package [or] doesn’t care what’s in the package.’
Record passive commitments represent ‘non-thinking money’ he adds, with many of these investors ‘forgetting their role in the economic chain’ as discriminating allocators
‘What’s troubling for us is that now 30% of the US market is owned passively, where no thought has gone into the selection of the underlying stocks and no interest is given to what they are. This is because they are only invested for three months at a stretch and some cases one week,’ he said.
His views were echoed by GAM’s Adrian Gosden, who argues that these products may not behave as historic performance would indicate.
‘An ETF that is tracking inflation may hold a basket of inflation-linked products or shares, for example property companies. However, even if they are in the same sector, a lot of these companies have very different make up and this may not be reflected,’ said Gosden, who manages the new launched GAM UK income fund.
‘And even if a company does what you want them to when the ETF is formed, companies are always changing, just because something went down in one interest rate cycle doesn’t mean it will do so again.’
Mark Northway, investment manager at Sparrows Capital, and an investor in ETFs said that while providing a huge amount of daily-dealing liquidity to the market, there was a risk that it emphasised capital flows at significant inflection points.
‘With most ETFs there is a market maker for the deals [to] strike on a daily basis, and there is a danger that should too many people want to sell their ETFs that this causes a bottleneck,’ he said.
‘Interestingly, it’s probably not just the unthinking money that would cause a situation like this, institutional money using an ETF as a liquid way of expressing a view on a market or theme could cause this type downward selling pressure.’
The short term nature of these investments has created a disconnect between the investor and the companies they buy, meaning they often do not understand what they own, says Plowden.
The growth in ‘dumb money’ that blindly follows increasingly complicated statistical constructs resembles the mortgage securitisation businesses that created the 2008 credit crisis, argues Plowden.
‘They just found a new bunch of suckers to sucker,’ he said. ‘What it most closely resembles for me is the whole industry that came up with credit backed securities and collateralised
‘Those bundled mortgages were a statistical construct that no one cared about what was in them and look how that went. It’s not contributing anything to the market, it’s not making capital raising cheaper or easier or protecting savers from volatility. It’s just boosting investment banker revenues quarter to quarter and it feels wrong in a way I can’t quite put my finger on.’
Walls of cash
However, Plowden pointed out that value investors may ultimately benefit by trading against a wall of undiscriminating cash.
These views were echoed by Northway, who argued that in a downturn, market makers, banks and brokers that provide liquidity to the ETFs that are redeemed daily, may hike their fees to take advantage of a sell-off.
‘As the market starts to fall fast the temptation for market makers to increase their bid/offer spreads say from 2p to 20p is too difficult to resist and they will likely in this situation make opportunistic profits.’
However, both Plowden and Northway agree that fears that passive managers are distorting valuations are baseless.
‘ETFs, because they invest in the entire index cannot change the relative price of the index,’ said Northway. ‘In fact, ETFs are price takers so their movements can exacerbate the market inefficiencies that are the bread and butter of active managers.’
Plowden added: ‘Increasing market inefficiencies caused by more passive investment should show why it makes sense to invest with your eyes open.’