The problem with ETFs

The ancient Greeks and Romans, while clever, never had anything approaching the technology developed during the enlightenment. Then the Antikythera mechanism turned up.

We know that ancient hunter gatherers, while anatomically no different to us, could not construct large buildings. Lacking agriculture, they simply did not have the surplus food needed to feed a population large enough to build urban landscapes like the Sumerians, who collectivized agriculture and invented cities. Then Gobekli Tepe turned up.

We also know that Aboriginal Australians have inhabited this continent while completely cut off from the rest of humanity, roughly along the Wallace line, for more than 50,000 years. Then some aboriginal DNA turned up in the bones of ancient native American Amazonians.

It was Mark Twain that said “it ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so”.  If there is a received wisdom in our current financial environment that everyone knows for sure, it is that passive investing is cheaper than active. I suspect that received wisdom will remain true, just until something turns up that proves it wrong.

Which brings me to ETFs.

Mark Monfort recently looked at the Australian ETF market, specifically for the most commonly held names across a range of ETFs. He found that of 155 ETFs he reviewed, CBA appeared in 19 of them with an average weight of 11%, BHP was in 18 ETFs with an average weight of 10.5%, Apple and Microsoft are in 19 and 16 ETFs, respectively, with average weights of 6.5% and 5.4%

Furthermore, the average weight of the top 10 holdings across those 155 ETFs was 44%.

While everyone knows that ETFs are a great way to get instant diversification, it turns out that building an ETF portfolio could lead you straight into massive concentration risk with the likes of Apple, Microsoft, CBA and BHP.

Moreover, the price investors pay for those stocks is of no concern to the index whatsoever. For example, when Tesla was recently included in the S&P 500, it went in with a weight of 1.7% at $695 per share. Thus, an investor attracted to the very low fees of an S&P 500 ETF was sending 1.7% of their investment to Tesla at a P/E of over 1,000. And then there is GameStop, which went from a 4% weight to 27% of the (US) GAMR ETF back in February and closed at 24% last night. These valuations may be nuts, but the indexes do not care.

Most fixed income indexes are liability weighted, so the largest issuers of debt have the highest weight. They also tend to be “long duration” due to the index’s requirement to measure the broad market. In February, as interest rates had their biggest move up since 1994, this exposure saw low fee fixed income ETFs fall by up to 4%, while most active fixed income managers stayed positive.

A fixed income index’s original job was to measure the returns of the market, but these days the index can earn far more using its holdings as a portfolio for an ETF or passive fund. While the ETF fees may be low, the portfolio is not optimized to navigate the historically low interest rate environment we inhabit.

ETFs are a great way of accessing a portfolio of stocks or bonds. Passive ETFs have led the way with low fees and transparent, broad based access to a particular asset class. It has been a good run, but recent outcomes in the fixed income market, valuation anomalies like Tesla and GameStop, and the overall concentration risk presented by the various indexes are starting to look like cracks in the wall of a dam.

A consensus has formed that passive investing is the cheapest and best way to invest. These small, unexpected anomalies may begin to sum and prove otherwise. In the meantime, you can always go active and access the increasing range of active ETFs that trade locally.

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