This month I’d like to touch on some of the problems that passive investing and ETFs have and their effect on the market. As we will see, the problem with ETFs is that it has become a huge business and rather than be constructed for investment purposes, it is constructed so that it can sell regardless of the foundation which it was built upon.
Tim du Toit sent me the excellent article on ExxonMobil (XOM) which is linked on the next page. I will discuss this along with other work on the topic. XOM operates in the oil & gas industry and is a holding in a great number of ETF strategies such as energy, dividend paying, value, large cap, quality dividend, low beta, S&P 500 ex-healthcare, defensive, covered call, etc. Based on ETFdb, it is a top 10 holding in at least 100 ETFs! One could say that’s natural considering its market cap and size. Oil (XOM’s business) took a huge hit as it dropped from over $120 to under $50 currently and earnings followed suit as EPS dropped 60% from its peak 2012 $9.70. So what happened to XOM stock? Nothing, as it still trades in the high 80s!!! Essentially demand from ETFs contributed to this anomaly.
Utility stocks have also been a major benefactor of ETFs as they are monopolies with dividend yields that are usually double that of the 10-year treasury. An example is Southern Company (SO) which trades at a premium to its own historical P/E and on par with the S&P. SO though has a 5-year growth rate of 1.6% and its market is at risk due to competition from alternative energy. Telecom also has a high dividend yield and is a “play” which saw competition permanently damage its profitability. Perhaps we will see utilities experience a similar event like telecoms. Note that AT&T and Verizon trade at P/E multiples that are 20-25% lower than SO. So utilities are at risk of being repriced lower. Although solar is only 0.6% of the market, it was 15% of all new electrical generation added in 2015 and 20% in 2014. Higher interest rates will also reduce profitability, and even if the sector succeeds in lobbying for high rates, this will turn consumers to solar even faster.
Low beta is also an investor favorite with over $22 billion in low beta ETFs vs under $100 million invested in high beta! The issue is one of statistic vs reality, and significant inflows can affect the result as the assets find support and are thus less volatile. Let’s take biotech companies. They are significantly riskier than the average company, and at their typical high valuation they are like lottery tickets. Most of them go to zero while a few hit it big. Despite this, according to Horizon Kinetics until the end of August 2015, the 3, 5 and 10-year beta of iShares Biotech ETF were below 1! Specifically they were 0.98, 0.76, and 0.67 respectively. Following the damaging publicity regarding the increase in drug prices, many biotech stocks dropped and beta rose above 1 as money outflows occurred. iShares MSCI Frontier 100 (FM) that has exposure in Kuwait (21%), Argentina (18% – defaulted 8 times), Pakistan (11%), Nigeria (8% – home of Boko Haram), and other such “low” risk locations has a 5-year raw beta of 0.50 (adjusted of 0.67) according to Bloomberg. So if you really believe that low beta is low risk then you should sell all you developed markets stocks and invest in FM. Hurry now! So you see there is nothing magically about beta. It does not predict future risk nor how the relationships can change. China and Romania have had stock exchanges from the eighteen hundreds. When the communists took over, both the Shanghai and Bucharest stock exchanges were closed in 1949. If someone ran the numbers in 1948, I’m sure they would conclude that these were uncorrelated, however a year later equity in both exchanges was wiped out. More recently, in 2007-8 the low beta mortgage bond indices sank into a black hole. The ABX mortgage index dropped 98%! Low beta will not protect you from volatility. The statistics are usually measured over 1, 3, and 5 years and may not capture the true volatility. For example, REITs in 2007-2009 where even Simon Property Group (SPG) dropped 70% (despite funds from operations (FFO) dropping only 20%). Finally, companies’ characteristics change over time: a once high-grower eventually matures (eg. McDonald’s, Coca-Cola), new competition impacts the future (eg. utilities, telecom). Smart beta believers should also take a look at Montier’s strong case against smart beta in a GMO paper (click here).
Indexing has essentially become one big momentum play and possibly the most crowded trade in the market. To add oil to the fire, momentum ETFs have come along and price appreciation brings in more flows to those stocks regardless of value. The effect of this can be seen in 2015 returns where essentially the top 10 stocks were the sole reason the market was positive. What is considered the market is not the market but 10 companies….
An ETF may not even fulfil its purpose, which is to fill a specific demand by investors. For example, an investor may want to invest in India. There are 765 companies with a market cap of over $100m and 490 with a market cap of over $250m. And there are 4 ETFs which can give you exposure to India: Wisdom Tree India Earnings Fund, iShares MSCI India ETF, Vanguard FTSE Emerging Markets ETF and the iShares MSCI Emerging Markets. These four funds alone allocate around $14b in India. “In 2014, according to the World Federation of Exchanges, the annual turnover at the two Indian exchanges was $732 billion, or about $3 billion per trading day.” The average daily turnover of the four mentioned ETFs is over $2 billion. Due to size, the two all-India ETFs have around half of their portfolio in the top 10 holdings. The average market cap of these 10 is around $35b, and obviously while based in India they are hardly an India play. About 20%+ of assets are in the top 3-5 companies such as Reliance Industries, Infosys, Tata Motors and Tata Consultancy which exhibit revenues outside of India of 55%, 97%, 85% and 94% respectively. So essentially your Indian ETF is anything but an investment in India.
In general investors expect ETFs to track its NAV, however on August 24th 2015, this did not happen. While the S&P 500 fell around 5%, the $65 billion iShares Core S&P 500 ETF (IVV) fell as much as 26%, the $18 billion Vanguard Dividend Appreciation ETF (VIG) and the $12 billion SPDR S&P Dividend (SDY) plunged 38% each, while the PowerShares S&P 500 Low Volatility ETF (SPLV) dropped 46% before retracing back, an hour after markets opened. The problem resulted from the regulations that were put in place following the 2010 flash crash and were expected to solve the problem which occurred. On the open that day, market makers widened the bid-ask spreads for both stocks and ETFs. When orders to sell at market were then executed at unusually low bids, trading was paused repeatedly in hundreds of ETFs and stocks. As a result the specialized traders, known as authorized participants, couldn’t engage in arbitrage that would restore the ETF to its fair value. Normally when an ETF’s price is out of line, the authorized participants buy the ETF and sell the shares (and vice-versa). When trading was halted in both the stocks and ETFs, this arbitrage couldn’t occur. Investors who had stop loss orders or used margin in place were butchered as stops and auto liquidation orders were triggered. Personally, I remember watching the S&P 500 e-mini futures contract (ES) live during that day. It was impossible to follow or even understand where the market was. I spoke to some traders over Skype. Even their trading platforms could not handle the flow of price data! One year later, what has changed? Well, according to Jenny Hadiaris, a stock market structure specialist at Deutsche Bank: “Be aware that not a whole lot has changed in the 10 months since our last ‘flash-crash’ like event. Many of these cracks have yet to be filled.”
Regarding the Value Investor Event at the end of September, please note that Bob Robotti (CEO of New York based Robotti & Company) will be joining us for what will be a very interesting one-on-one.
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