The problem with ETFs

The Big Short’s Michael Burry has likened passive index funds and ETFs to subprime CDOs. He is the guy who made a small fortune betting against CDOs in 2007-2008.

We have all heard about the untested nature of exchange-traded funds in a market downturn, and as fears for a precipitous market sell-off bubble quietly under the headlines, it’s probably worth having a quick look at what he thinks the problem is.

He says a bubble has blown up in passive investing, its not a contention, its a fact:

It has happened for all sorts of reasons, the inability of active fund managers to outperform is the most obvious marketing line for ETFs and passive funds, but having chatted to some US fund managers and stockbrokers one of the major drivers has been a move in America away from direct share broking with a focus on commission, to “wealth management” by brokers looking for an annuity stream rather than a daily commission. Share trading is fast becoming seen as a ‘poor man’s’ business in the US, a low life activity and they laugh at us for continuing to do it.

Brokers moving to annual fees for the management of your investments rather than commissions on today’s trades has been happening here as well to a much lesser extent, and the growth in ETFs and passive funds is much more muted here. But in the US the transition has occurred earlier and has driven the growth in the ETF industry as traditional brokers and advisers have moved away from the high touch, high vigilance, high activity, high risk, high admin, expensive, low value add, hands on business of direct share trading to putting clients into a mix of passive ETF’s which excludes them from having to have stock ideas and manage shareholdings, whilst at the same time pleasing their compliance departments with the lack of volatility and risk plus the 'more sensible' diversification into hundreds of shares represented by a few ETFs.

The previously extremely active and risky share transaction-based commission-driven business of stockbroking has taken an ETF Valium and are addicted. Its been a wonderful transition, the advice industry is now charging their clients the same management fee for managing a few benign ETF’s which represent passive asset classes.

Same money, more reliable income, much less activity, much less risk for the client, happy compliance department, more lunches. Great in a bull market, only having to trouble your clients when there are seismic events, and even then, the advice will probably be "we are well diversified, we don't need to do anything'. And there are no fund managers to cock it up making mistakes with their active meddling; it is all passive investment. The only value add the adviser needs to deliver is deciding what asset class to invest in in what weighting and that doesn’t need revisiting often if at all. Happy Days.

ETF’s have been a fabulous invention for the broking industry no blame, no activity, less risk, same money.

So what’s the problem? The problem is liquidity.

Michael Burry describes the recent flood of money into index funds as having parallels with the pre-2008 bubble in the CDOs. Absolutely fine while everyone pays their mortgage, or in the case of passive investments, when the market goes up, but they are a bull market investment and should the market ever have a precipitous collapse, and everybody tries to exit at the same time, the liquidity isn’t there, investors will get trapped.

It would take a pretty extreme event to trigger the problem, a run on the stock-market, but the problem is this as described by Michael Burry:

“In the Russell 2000 Index, the vast majority of stocks are lower volume, lower value-traded stocks. Today I counted 1,049 stocks that traded less than $5 million in value during the day. That is over half, and almost half of those, 456 stocks, traded less than $1 million during the day. Yet through indexation and passive investing, hundreds of billions are linked to stocks like this. The S&P 500 is no different, the index contains the world’s largest stocks, but still, 266 stocks, over half, traded under $150 million today. That sounds like a lot, but trillions of dollars in assets globally are indexed to these stocks. The theatre keeps getting more crowded, but the exit door is the same as it always was. All this gets worse as you get into even less liquid equity and bond markets globally.”

While activity is “normal” the passive funds and the ETF’s can create and dismantle their exposures. But when everybody tries to sell the index, they simply won’t be able to at market prices and the pricing structure will break down taking the market down, more precipitously than it would if there weren't passive funds. The problem is the disconnect between the client and the market. The client will simply expect to sell the ETF, but the middle man, the ETF provider, won't be able to cover themselves and who knows who will take the fall, the ETF seller, or the ETF provider. I think you know the answer to that one.

The lack of execution will be followed by a lot of excuses from the passive fund providers and the ETF creators, blaming whatever event it was that created the run, but the ultimate price will be paid by the investors.

Interestingly the Japanese have insured against this with the bank of Japan owning big holdings in the largest ETF’s in Japan meaning that they will provide stability in a global panic, those ETF’s are relatively protected compared to US, European and Asian passive funds and ETF’s.

Conclusion - your risk in passive funds is when everybody tries to do the same thing at once, when one of those once-in-a-lifetime events occur. An aeroplane hits a building, the New York Stock Exchange reopens after being closed for a month by a nuclear bomb, China invades Hong Kong, Trump is carried away in a straitjacket, bond yields go from negative to +5% overnight as the bond bubble bursts. One of those once-in-a-lifetime events that happen once a decade. That’s when the problem will arise. It is low odds, but it is untested.

Derivative risk - Michael Burry also goes on to highlight the derivative risk of a passive fund sell-off noting “the impossibility of unwinding the derivatives and naked buy/sell strategies used to help so many of these funds pseudo-match” their underlying asset class. Some of the passive funds and ETFs are synthetic, and the other side of their derivatives contracts are going to give them the same excuses that they will give their investors - "Sorry can't trade, not our fault, blame the terrorist, the aeroplane, Trump, China...."

Timing unknown - Before you go and sell all your ETFs, understand that we are talking about an extreme event at the far end of the normal distribution curve of the stock-market and as Michael Burry points out, “I just don’t know what the timeline will be. Like most bubbles, the longer it goes on, the worse the crash will be”.

So business as usual. Despite our recent caution and our move to cash, a precipitous market event is very unlikely, we are trying to avoid a correction, not a crash, and will be looking to buy back in just as soon as it looks safe(r).

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Marcus Padley is the author of the Marcus Today stock market newsletter. To sign up for a 14-day free trial please click here.