ETFs, ETPs behind stock boom, but could worsen its bust

PASSIVE investment has become so popular that it is a key reason for the ongoing bull market.

Month by month, money has been pouring into low-cost exchange- traded funds (ETFs) and other exchange-traded products (ETPs), according to ETFGI, which monitors the index investments.

The growth has been extraordinary, with total assets of ETFs and ETPs surging from under US$500 billion in 2005 to almost US$4.5 trillion in August this year.

Index-tracking funds and products, which now total just over 7,000, have outperformed most active hedge and mutual fund managers by a sizeable margin, according to Deborah Fuhr, who founded and heads ETFGI. Such have been the results, that professional and amateur investors are choosing ETFS to diversify into multi-nation equities, bonds and commodities.

Growing numbers of investors are taking the view that it is a waste of time picking stocks and building up their own portfolios, with variable results. All they need to do is choose different ETFs for allocations in the US, Europe, Asia and elsewhere.

The biggest providers of ETFs are iShares, Vanguard and SPDR, according to ETFGI. The assets of US ETFs and ETPs are almost US$3.2 trillion, while those in Europe amount to US$725 billion. The number of such products in the Asia-Pacific, excluding Japan ETFs and ETPs, has soared from 35 in 2005 to 1,134 in August this year and are worth around US$150 billion.

Critics of ETFs say that indices such as S&P500 have become overloaded with so-called FAANG stocks, notably Facebook, Amazon, Apple, Netflix and Google and also shares such as Microsoft. The price earnings ratios of these shares have soared to overvalued levels. Critics say that if earnings of these super-growth companies disappoint, their shares could fall, causing the values of key ETFs to decline, leading to sales of the products, rendering brokers to sell more individual share constituents of the indices. Any market decline would then accelerate.

In other words, the impressive growth of ETFs in the current bull market could be a “Sword of Damocles” when equities eventually peak.

Anthony Davidow, an asset allocation strategist at investment service company Charles Schwab, contends that these fears are exaggerated as there are numerous types of ETFs and ETPs. Despite the ETFs’ impressive growth, they account for only about 6 per cent of the US stock market, compared to around 23 per cent for mutual funds, he estimates. Households, pension funds, international investors, hedge funds and other investors also own stocks.

“In other words, there are still plenty of parties in the market buying and selling shares for a variety of reasons,” Mr Davidow says. He also believes that the market in ETF assets is liquid and efficient.

Outside of a few extreme cases, such as flash crashes, “ETF trading has been very orderly and it has allowed investors to move in and out of markets with ease”, he adds, although he believes it is advisable that investors have stop-loss orders to protect themselves.

In contrast, Hans Redeker, global head of foreign-exchange strategy at Morgan Stanley, says he is concerned about the “herd mentality” of passive investors who are buying ETFs and other index-tracking products.

If their investments begin to decline and they begin selling, they could cause a “cascade effect”. Fund managers pursuing active stock-picking strategies would have to buy to stabilise the market, but there is no guarantee that they would do so.

© Copyright Neil Behrmann

This article was first published in The Business Times, Singapore

Jack of Diamonds, the sequel to Trader Jack- The Story of Jack Miner will be published in early this year. Neil is also author of anti-war children’s novel Butterfly Battle- The Story of the Great Insect War.  The updated 2015 Waterloo commemoration version of Butterfly Battle is on Kindle and e-books. Reviews are on neilbehrmann.net and Amazon and more reviews are welcome. If the books are purchased direct on this site, a proportion of the proceeds will go to low cost charities

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