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Howard Marks Sounds The Alarm On ETFs And Passive Investing, Again

Back in March 2015, Howard Marks was among the first to sound the alarm on the encroaching danger posed by both ETFs in particular, and passive investing in general, when he memorably asked (rhetorically, for now), "what would happen, for example, if a large number of holders decided to sell a high yield bond ETF all at once?" and answered his own question:

"in theory, the ETF can always be sold. Buyers may be scarce, but there should be some price at which one will materialize. Of course, the price that buyer will pay might represent a discount from the NAV of the underlying bonds. In that case, a bank should be willing to buy the creation units at that discount from NAV and short the underlying bonds at the prices used to calculate the NAV, earning an arbitrage profit and causing the gap to close. But then we’re back to wondering about whether there will be a buyer for the bonds the bank wants to short, and at what price. Thus we can’t get away from depending on the liquidity of the underlying high yield bonds. The ETF can’t be more liquid than the underlying, and we know the underlying can become highly illiquid."

Not to make a too fine a point of it, Marks underscored just how profound the role of liquidity can be at a time when everyone needs it, and none is available:

In September 2008, AIG experienced serious liquidity issues (despite its $1 trillion balance sheet) when it couldn’t post $20-25 billion of liquid collateral related to credit default swap contracts written by one of its subsidiaries. The U.S. government stepped in as a result, lending support that eventually reached $182.3 billion, massively diluting AIG shareholders in the process. When you can’t meet a margin call because you have insufficient liquidity, that’s profound.

In the ensuing two years, while the ETF market has only gotten more "liquid" (at least in a time when liquidity wasn't actually needed), the underlying bond market has seen bid/ask spreads widen as liquidity in single-name securities has shrunk. This has not been a purely credit-linked concern, as increasingly more ETF-linked "events" have emerged in other asset classes, including the most liquid one: equities.

Fast forward to today, when the Oaktree co-chairman, in his latest memo titled "There They Go Again... Again" has not only shared his broader thoughts on markets and the current investing environment, as follows...

  • The uncertainties are unusual in terms of number, scale and insolubility in areas including secular economic growth; the impact of central banks; interest rates and inflation; political dysfunction; geopolitical trouble spots; and the long-term impact of technology.
  • In the vast majority of asset classes, prospective returns are just about the lowest they’ve ever been.
  • Asset prices are high across the board.  Almost nothing can be bought below its intrinsic value, and there are few bargains.In general the best we can do is look for things that are less over-priced than others.
  • Pro-risk behavior is commonplace, as the majority of investors embrace increased risk as the route to the returns they want or need.

... which however he doesn't go so far as describing it as a "bubble", but - among others - discusses his latest views on what many believe is the biggest risk to market structure and overall risk stability: ETFs and Passive Investing.

And here, once again, Marks sounds the alarm on not only on ETFs, but the exponentially growing passive investor sector, which is soaking up hundreds of billions in capital from active managers, in the process creating perhaps what may be the biggest bubble ever, one which - ironically - takes place with no fundamental analysis whatsoever. The key quotes:

Given the generally lagging performance of active managers over the last dozen or so years, as well as the creation of ETFs, or exchange-traded funds, which make transacting simpler, the shift from active to passive investing has accelerated.  Today it’s a powerful movement that has expanded to cover 37% of equity fund assets.  In the last ten years, $1.4 trillion has flowed into index mutual funds and ETFs (and $1.2 trillion out of actively managed mutual funds).

* * *

As a product of the last several years, ETFs’ promise of liquidity has yet to be tested in a major bear market, particularly in less-liquid fields like high yield bonds.

* * *

... as ETFs attract capital, they have to buy large amounts of these stocks, further fueling their rise.  Thus, in the current up-cycle, over-weighted, liquid, large-cap stocks have benefitted from forced buying on the part of passive vehicles, which don’t have the option to refrain from buying a stock just because its overpriced... Is Apple a safe stock or a stock that has performed well of late?  Is anyone thinking about the difference?

* * *

... what should we think about the willingness of investors to turn over their capital to a process in which neither individual holdings nor portfolio construction is the subject of thoughtful analysis and decision-making, and in which buying takes place regardless of price?

* * *

Like the tech stocks in 2000, this seeming perpetual motion machine is unlikely to work forever.  If funds ever flow out of equities and thus ETFs, what has been disproportionately bought will have to be disproportionately sold.  It’s not clear where index funds and ETFs will find buyers for their over-weighted, highly appreciated holdings if they have to sell in a crunch. 

* * *

Finally, the systemic risks to the stock market have to be considered.  Bregman calls “the index universe a big, crowded momentum trade.”  A handful of stocks – the FAANGs and a few more – are responsible for a rising percentage of the S&P’s gains, meaning the stock market’s health may be overstated.

* * *

More in the full excerpt below (source):

Passive Investing/ETFs

Fifty years ago, shortly after arriving at the University of Chicago for graduate school, I was taught that thanks to market efficiency, (a) assets are priced to provide fair risk-adjusted returns and (b) no one can consistently find the exceptions.  In other words, “you can’t beat the market.”  Our professors even advanced the idea of buying a little bit of each stock as a can’t-fail, low-cost way to outperform the stock-pickers.

John Bogle put that suggestion into practice.  Having founded Vanguard a year earlier, he launched the First Index Investment Trust in 1975, the first index fund to reach commercial scale.  As a vehicle designed to emulate the S&P 500, it was later renamed the Vanguard 500 Index Fund.

The concept of indexation, or passive investing, grew gradually over the next four decades, until it accounted for 20% of equity mutual fund assets in 2014.  Given the generally lagging performance of active managers over the last dozen or so years, as well as the creation of ETFs, or exchange-traded funds, which make transacting simpler, the shift from active to passive investing has accelerated.  Today it’s a powerful movement that has expanded to cover 37% of equity fund assets.  In the last ten years, $1.4 trillion has flowed into index mutual funds and ETFs (and $1.2 trillion out of actively managed mutual funds).

Like all investment fashions, passive investing is being warmly embraced for its positives:

  • Passive portfolios have outperformed active investing over the last decade or so.
  • With passive investing you’re guaranteed not to underperform the index.
  • Finally, the much lower fees and expenses on passive vehicles are certain to constitute a permanent advantage relative to active management.

Does that mean passive investing, index funds and ETFs are a no-lose proposition?  Certainly not:

  • While passive investors protect against the risk of underperforming, they also surrender the possibility of outperforming.
  • The recent underperformance on the part of active investors may well prove to be cyclical rather than permanent.
  • As a product of the last several years, ETFs’ promise of liquidity has yet to be tested in a major bear market, particularly in less-liquid fields like high yield bonds.

Here are a few more things worth thinking about:

Remember, the wisdom of passive investing stems from the belief that the efforts of active investors cause assets to be fairly priced – that’s why there are no bargains to find.  But what happens when the majority of equity investment comes to be managed passively?  Then prices will be freer to diverge from “fair,” and bargains (and over-pricings) should become more commonplace.  This won’t assure success for active managers, but certainly it will satisfy a necessary condition for their efforts to be effective.

One of my clients, the chief investment officer of a pension fund, told me the treasurer had proposed dumping all active managers and putting the whole fund into index funds and ETFs.  My response was simple: ask him how much of the fund he’s comfortable having in assets no one is analyzing.

As Steven Bregman of Horizon Kinetics puts it, “basket-based mechanistic investing” is blindly moving trillions of dollars.  ETFs don’t have fundamental analysts, and because they don’t question valuations, they don’t contribute to price discovery.  Not only is the number of active managers’ analysts likely to decline if more money is shifted to passive investing, but people should also wonder about who’s setting the rules that govern passive funds’ portfolio construction.

The low fees and expenses that make passive investments attractive mean their organizers have to emphasize scale.  To earn higher fees than index funds and achieve profitable scale, ETF sponsors have been turning to “smarter,” not-exactly-passive vehicles.  Thus ETFs have been organized to meet (or create) demand for funds in specialized areas such as various stock categories (value or growth), stock characteristics (low volatility or high quality), types of companies, or geographies.  There are passive ETFs for people who want growth, value, high quality, low volatility and momentum.  Going to the extreme, investors now can choose from funds that invest passively in companies that have gender-diverse senior management, practice “biblically responsible investing,” or focus on medical marijuana, solutions to obesity, serving millennials, and whiskey and spirits.

But what does “passive” mean when a vehicle’s focus is so narrowly defined?  Each deviation from the broad indices introduces definitional issues and non-passive, discretionary decisions.  Passive funds that emphasize stocks reflecting specific factors are called “smart-beta funds,” but who can say the people setting their selection rules are any smarter than the active managers who are so disrespected these days?  Bregman calls this “semantic investing,” meaning stocks are chosen on the basis of labels, not quantitative analysis.  There are no absolute standards for which stocks represent many of the characteristics listed above.

Importantly, organizers wanting their “smart” products to reach commercial scale are likely to rely heavily on the largest-capitalization, most-liquid stocks.  For example, having Apple in your ETF allows it to get really big.  Thus Apple is included today in ETFs emphasizing tech, growth, value, momentum, large-caps, high quality, low volatility, dividends, and leverage.

Here’s what Barron’s had to say earlier this month:

With cap-weighted indexes, index buyers have no discretion but to load up on stocks that are already overweight (and often pricey) and neglect those already underweight.  That’s the opposite of buy low, sell high.

The large positions occupied by the top recent performers – with their swollen market caps – mean that as ETFs attract capital, they have to buy large amounts of these stocks, further fueling their rise.  Thus, in the current up-cycle, over-weighted, liquid, large-cap stocks have benefitted from forced buying on the part of passive vehicles, which don’t have the option to refrain from buying a stock just because its overpriced.

Like the tech stocks in 2000, this seeming perpetual motion machine is unlikely to work forever.  If funds ever flow out of equities and thus ETFs, what has been disproportionately bought will have to be disproportionately sold.  It’s not clear where index funds and ETFs will find buyers for their over-weighted, highly appreciated holdings if they have to sell in a crunch.  In this way, appreciation that was driven by passive buying is likely to eventually turn out to be rotational, not perpetual.

* * *

Finally, the systemic risks to the stock market have to be considered.  Bregman calls “the index universe a big, crowded momentum trade.”  A handful of stocks – the FAANGs and a few more – are responsible for a rising percentage of the S&P’s gains, meaning the stock market’s health may be overstated.

All the above factors raise questions about the likely effectiveness of passive vehicles – and especially smart-beta ETFs.

  • Is Apple a safe stock or a stock that has performed well of late?  Is anyone thinking about the difference?
  • Are investors who invest in a number of passive vehicles described in different ways likely to achieve the diversification, liquidity and safety they expect?
  • And what should we think about the willingness of investors to turn over their capital to a process in which neither individual holdings nor portfolio construction is the subject of thoughtful analysis and decision-making, and in which buying takes place regardless of price?