There has been a substantial amount written about the systemic risks that ETF can cause when they account for a certain percentage of the total market. The benefits of ETF are obvious, as large money managers (charging hefty fees) have increasingly looked like local index investors. Fidelity Canada's Canadian fund is effectively a replication with a 93% correlation to the TSX60 and as such with fees of nearly 1% of AUM, the attractiveness of buying a simple TSX60 ETF is almost overwhelming. Who would not want to reduce its money management fees by 99%...
Back to our problem, ETF investors are not "investors" they ride the coat tail of the publicly listed index -- taking no investor selection position (aside from being in or out of the market). In fact, the ETF investors invest in sectors, not companies.
As long as ETFs were a small percentage of the market it was not too serious, and a substantial body of research has been written on what is the right level of ETFs until they cause a problem -- some said it was near 70% of the market other as low as 20%, but the consensus is that at the 50% level (where we are today) event risks with large liquidity implications can seriously affect the overall market because of the behavior of ETF investors.
Outside the ETF market, there is another issue insofar as market liquidity has already been compromised since 2008 -- the idea was to de-risk the deposit takers in large financial institutions by curtailing the ability of these banks to trade for their own account (i.e. hold inventory). This was a major source (often contrarian) of liquidity that is no longer there.
Take the average ETF holder with a very limited understanding of what makes an investment good or bad and who has "abdicated" his investment strategy to the market by buying index funds via the ETF markets -- In the event of a market disruption, that investor has a simple strategy -- hold or sell. He cannot differentiate between different investments because he doesn't follow the companies he's "invested-in" he has given that task to the market.
So in the event of a crisis this investors' binary portfolio decision has global impact -- at a time where little liquidity is present -- let say that only 10% of ETF investors decide to sell -- partly because they want to be cautious and move to fixed income. should these 10% only be 20% of the overall market the total percentage of sale will be 2%, but if it is 50% then its 5% of the total market that is looking to sell, in an already low liquidity environment...
Good fund managers have been poor at explaining why they are, in the long run, a better bet than ETF, partly because they too use the market's false premise as a guide to future performance -- which is at the source of the increased event-driven risk: All investment models are built on the past 40 years of data. this period market the following (a) the stock market had low p/e, (b) the baby boomer were entering the most profitable part of their work-life and (c) were starting to save (and invest), (d) interest rates were very high (above 15%) and were starting to fall.
Today, the babyboomers are exiting the workforce and are starting the process of liquidating their assets to meet their cash flow requirements, stock prices (as a function of earnings) have never been as high, interest rates are near zero with little room to go much lower.
The implication of this is that the trend of the past 40 years is impossible to continue for the next 40 years. The assumptions that are the bases of all these fancy algorithms are false, and the players know it, hence the inability of most active managers to say what the future holds.
The risk of deflation and of miserable yields on the stock market are higher, that price deflation (lower house prices) is higher than the algorithms would seem to indicate. In fact, adding the period from 1970-1979 to the algos would seriously alter the performance and risks of a lot of strategies.
I take the view that ETFs are a market weapon of destruction, however, I firmly believe that nothing will be done about it until a crisis occurs, and by then it will be too late
Back to our problem, ETF investors are not "investors" they ride the coat tail of the publicly listed index -- taking no investor selection position (aside from being in or out of the market). In fact, the ETF investors invest in sectors, not companies.
As long as ETFs were a small percentage of the market it was not too serious, and a substantial body of research has been written on what is the right level of ETFs until they cause a problem -- some said it was near 70% of the market other as low as 20%, but the consensus is that at the 50% level (where we are today) event risks with large liquidity implications can seriously affect the overall market because of the behavior of ETF investors.
Outside the ETF market, there is another issue insofar as market liquidity has already been compromised since 2008 -- the idea was to de-risk the deposit takers in large financial institutions by curtailing the ability of these banks to trade for their own account (i.e. hold inventory). This was a major source (often contrarian) of liquidity that is no longer there.
Take the average ETF holder with a very limited understanding of what makes an investment good or bad and who has "abdicated" his investment strategy to the market by buying index funds via the ETF markets -- In the event of a market disruption, that investor has a simple strategy -- hold or sell. He cannot differentiate between different investments because he doesn't follow the companies he's "invested-in" he has given that task to the market.
So in the event of a crisis this investors' binary portfolio decision has global impact -- at a time where little liquidity is present -- let say that only 10% of ETF investors decide to sell -- partly because they want to be cautious and move to fixed income. should these 10% only be 20% of the overall market the total percentage of sale will be 2%, but if it is 50% then its 5% of the total market that is looking to sell, in an already low liquidity environment...
Good fund managers have been poor at explaining why they are, in the long run, a better bet than ETF, partly because they too use the market's false premise as a guide to future performance -- which is at the source of the increased event-driven risk: All investment models are built on the past 40 years of data. this period market the following (a) the stock market had low p/e, (b) the baby boomer were entering the most profitable part of their work-life and (c) were starting to save (and invest), (d) interest rates were very high (above 15%) and were starting to fall.
Today, the babyboomers are exiting the workforce and are starting the process of liquidating their assets to meet their cash flow requirements, stock prices (as a function of earnings) have never been as high, interest rates are near zero with little room to go much lower.
The implication of this is that the trend of the past 40 years is impossible to continue for the next 40 years. The assumptions that are the bases of all these fancy algorithms are false, and the players know it, hence the inability of most active managers to say what the future holds.
The risk of deflation and of miserable yields on the stock market are higher, that price deflation (lower house prices) is higher than the algorithms would seem to indicate. In fact, adding the period from 1970-1979 to the algos would seriously alter the performance and risks of a lot of strategies.
I take the view that ETFs are a market weapon of destruction, however, I firmly believe that nothing will be done about it until a crisis occurs, and by then it will be too late
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