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An ETF bubble? Here’s what we think

Jack Amy and Andrea Rocchi

The active versus passive debate has been the centrepiece of discussions within the financial industry over recent years, fuelled by the surge in popularity of Exchange Traded Funds (ETFs).

In little over a decade, global assets jumped from $800 billion to $5.65 trillion at the end of August 2019, according to industry data provider ETFGI. But this express train to stardom hasn’t come without its controversies and criticism.  

The latest person to join the dissenters has been Michael Burry, who gained infamy as the hero of The Big Short and was brought to life on the big screen by Christian Bale. The illustrious fund manager famously identified – and profited from – the subprime mortgage bubble, which nearly destroyed the global financial system. 

More than a decade on and Burry has turned his focus to a particular corner of the burgeoning ETF universe; specifically the smaller companies market, drawing parallels with the bubble he spotted in collateralized debt obligations (CDOs) before the 2008 global financial crisis. 

What was the CDO bubble?

CDOs are a complex piece of financial engineering. Large financial institutions package thousands of individual loans together into one product, in a process called securitisation. These are then sold onto investors who choose their level of risk.  

Before the 2008 crisis, these loans were mostly mortgages. The low risk options would include debt from borrowers with a high credit rating and those who typically pay their mortgages early. The higher risk options were composed of debt from borrowers with a lower credit quality and those who were unlikely to ever pay their loans back – known as subprime borrowers.

In the subprime mortgage crisis, CDOs made these pooled mortgage-backed securities more complex, allowing investors to speculate on the outcome of the underlying products, like whether or not they are likely to default on their loan repayments. In the end, the market speculating on the outcome of these products was worth 20 times more than the amount originally lent out to home-buyers. 

These investments were perceived as relatively safe and diversified investment opportunities by institutions, yet this speculative imbalance channeled excessive leverage into global real estate markets. As a result, CDOs magnified swings in an unstable housing market, meaning the subsequent housing market crash permeated into one of the worst financial crises in modern history.

Parallels between ETFs and CDOs 

After many years out of the limelight, Burry has now voiced concerns that ETF prices are being manipulated by large capital flows into the market, rather than the traditional security-level analysis that goes into the valuation of individual assets. This, he reckons, has fuelled an ETF bubble.

This issue is particularly prevalent in the smaller companies market. Whilst it gives the illusion of price stability and liquidity (investments that are easy to buy and sell without an impact on the price), he does not believe there are actually enough buyers and sellers to support the ecosystem if a large portion of the market decides it wants to sell. 

If the price of the ETF were to fall quickly, reduced liquidity could leave investors with little option than to accept a lower price if they want to get out of the market.

Our view on the distortion of prices in smaller companies

In regards to the manipulation of prices in the smaller companies sector, it’s true that it’s just a small fraction of the flows into the ETF market that have been directed to companies with a small market capitalisation. 

ETF liquidity is valued at two levels: the underlying basket of investments and the ETF security itself. Aware of this, ETF issuers focus on larger and more liquid indices. This has encouraged the market to offer more mainstream instruments, hence a skew to larger companies in the ETF market. 

However, the large flows into large cap ETFs is more of a consequence than a cause of the lower interest in smaller company ETFs. We’ve been living in an economic cycle that favours larger companies and economies of scale, so the smaller company sector has underperformed due to weaker fundamentals.

The underperformance of smaller companies is also an extension of the underperformance of value investments compared to growth stocks. As ETFs are commonly weighted by market capitalisation, the majority of the ETFs have reflected this dynamic shift away from a focus on value opportunities (smaller companies).

Whilst there may be some merit in Burry’s argument of distorted price discovery, ETFs are definitely not the cause of it. In fact, it’s quite the opposite. 

There has been a growing lack of trust in traditional active managers since the financial crisis, driven by poor returns. Even before the ETF boom, many so-called active investors were using passive investments in their strategy. This means real investors were paying active fees for funds that were invested in passive investments. We’re confident that if the price discovery becomes distorted, skilled active manager will start to greater value to investors.

We’re not against active management, but we are against investors having to pay expensive fees for negligible returns.

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Our view on the comparison of ETFs to CDOs

The ETF market has its risks. Yet we believe it’s unfair to compare the entire ETF market with the CDOs that caused a financial crash so severe it threatened the entire financial system. 

The 2008 financial crash was so severe due to the lethal combination of leverage (borrowed financial instruments or capital), complex financial engineering and conflicts of interest within the organisations creating the CDOs. 

Whilst it’s possible to get exposure to synthetic ETFs that use derivatives and swaps to track underlying investments – similar to CDOs – the majority of the passive market is made up of physical ETFs, which means they own the underlying asset they are invested in. 

By buying ETFs shares, at least for the physical  ones, you don’t speculate on an asset class, but you actually own shares of the underlying instruments. This is similar to normal funds and is not exclusive to ETFs.

ETFs do, however, expose investors to daily liquidity risk, which can act as a double layer of unwanted costs for investors: premium/discount and market spread. An ETF tracking the FTSE 100, for example, may trade at a premium or discount to the underlying index in the short term due to changing demand levels of the ETF itself. Over time (usually minutes/hours) market makers correct the arbitrage, but this highlights why ETFs aren’t appropriate for high frequency trading.

 Instead they are much more suited for long-term portfolios. At Moneyfarm, we build our portfolios with a ten-year time horizon as we believe this is the most effective way to maximise returns. 

Why investment advice is important

When judging the merits of investment products and strategies, it’s easy to look for a binary answer. But the reality is that no investment strategy or product is suitable for every single investor. Your time horizon and financial situation will impact how much risk you can take with your investments, and thus what investment strategy and products you should adopt. 

Whether investing in an ETF or not, we believe that every investor should have access to quality investment advice on fully-managed portfolios. At Moneyfarm, our portfolios are managed in line with the risk profiles of our investors. This means that each investment and market is scrutinised to ensure it reflects the needs and demands of our investors. 

Why Moneyfarm invests in ETFs

At Moneyfarm we want to offer our investors greater flexibility and help maximise returns. We choose to invest in ETFs for their low cost diversification, wide exposure to all asset classes, transparency and liquidity. 

ETFs are widely praised for providing retail investors with crucial transparency; it’s easy to understand exactly what you’re invested in, how much risk you’re taking with your money, and whether this is suitable for your financial situation.  

At Moneyfarm, we’re always holding ourselves up to scrutiny. Our experienced fund managers monitor the markets every day, evaluating thousands of ETF products listed on the London Stock Exchange in line with market trends.

We score ETFs by asset class, according to the following criteria:

  • Underlying index
  • Fund liquidity and size
  • Replication strategy
  • Performance
  • Cost of ownership
  • Lifecycle
  • Security lending
  • Issuer quality

We believe diversification is important to manage the sector-specific risks in our portfolios, so we build our portfolios with globally diversified ETFs. 

ETFs might be passive instruments, but that doesn’t mean an investment portfolio based on ETFs involves no active decision-making.

Far from it. The enormous choice of ETFs – which some say now outnumbers individual equities –  gives investment managers many opportunities to refine and tune portfolios.

Most of Moneyfarm’s equity ETFs are weighted by exposure to market capitalisation, but we make an active choice in deciding which benchmark to use. Should it be an ETF that weighs all stocks in the index equally, or one that sorts companies by profitability?

In our view, investors currently have a wider choice at a lower cost than traditional active fund management. Although Moneyfarm uses passive instruments, we don’t take a passive approach to investing.

So our selection process is incredibly important to ensure we’re building the right portfolios to help our investors reach their financial goals. 

If you’ve got any questions on our Investment Strategy, you can get in touch with one of our Investment Consultants, or subscribe to watch our Monthly Market Updates with CIO Richard Flax on our Youtube Channel.

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As with all investing, your capital is at risk. The value of your portfolio with Moneyfarm can go down as well as up and you may get back less than you invest.