Dislocations

By Guest Blogger Ryan Lewenza

A few weeks ago I was speaking at an ETF conference in Montreal where Matt Hougan, chairman of Inside ETFs, predicted that Canadian mutual funds would never outsell ETFs again. Last year Canadian ETFs had net sales of $19.8 billion while mutual funds saw negative sales of $2.7 billion, representing the first time in a decade that ETFs outsold mutual funds. Matt’s prediction received some pretty good media attention to say the least, I’m sure to the chagrin of many of the mutual fund companies and banks that sell mutual funds.

While I’m not so bold as to say that ETFs will outsell mutual funds every year going forward, I definitely agree with Matt that ETFs are the future and that more and more investors will dump their high-cost, ineffective mutual funds for low-cost ETFs. But, as this trend plays out, some worry that it will lead to market dislocations, such as increased market volatility and a decrease in price discovery. Price discovery refers to the process of determining the price of an asset through the interactions of buyers and sellers.

Some believe that as money flows into ETFs and passive investments, like an S&P 500 index ETF, that fund flows are driving stock prices and the equity markets versus investors buying stocks based on their underlying fundamentals. They contend that ETF purchases are pushing up stock prices and valuations of the largest stocks (e.g., the FANG stocks) while undervaluing smaller and out-of-favour stocks. This week I attempt to debunk these concerns.

The first point to make is that I believe some are overplaying and overestimating the size and impact of ETFs on the capital markets. While ETFs are experiencing large investor flows they still represent a fraction of the overall capital markets. According to Blackrock, U.S. stock ETFs accounted for just 8.5% of the total market, meaning over 90% of the U.S. equity market is made up of individual stocks, mutual funds and non-ETF investments. For the bond markets ETFs make up an even smaller percentage at 1.4% of the total U.S. bond market. ETFs still only represent a small fraction of the capital markets so those ETF critics talking about how much ETFs are impacting the markets are just spinning a narrative rather than reflecting what’s actually going on.

ETFs Represent a Small Fraction of the Total Market

Source: SIFMA, Bloomberg, BlackRock

Another interesting way to hit home this point (that ETFs are not having a demonstrative impact on the markets) is to compare the amount of ETFs traded versus their absolute flow. To understand this you first need to understand how an ETF actually works.

ETF shares are created by a process called creation and redemption. More specifically, the ETF company creates a new ETF by working with an “Authorized Participant”, which can be a market maker or large investment firm. The AP buys and delivers the underlying securities to the ETF company. For example, say Blackrock wants to create a new ETF that tracks the S&P 500, the AP will buy shares of the 500 companies in the S&P 500 based on their weights within the index. In exchange, Blackrock provides units or shares of equal value to the AP, usually in blocks of 50,000. So now we have 50,000 shares or units of this S&P 500 ETF.

Now when it starts trading in the market, buyers and sellers are simply trading back and forth these 50,000 shares of the S&P 500 ETF. No new units are being created or redeemed, so no new money is flowing into the S&P 500 companies. Occasionally new money will come into the ETF, which will require the creation of new additional units, but generally speaking, after the ETF has been created buyers and sellers are just exchanging the ETF shares.
Why does this matter?

The creation of new ETF shares represents an even smaller percentage of overall trading activity. Look at the chart below. It calculates the percentage of US equity ETFs traded as a percentage of all US stocks traded and that equates to about 25%. However, when you look at the absolute flow of equity ETFs traded (the amount created in new units) it represents just 1.8% of all trading volume. Essentially, after the ETF units have been created any buys and sells of the ETF are not impacting the actual stocks in the index, hence why these concerns over ETFs are overstated.

Creation of ETFs Represent Just 1.8% of Absolute Trading Volume

Source: NBF, Bloomberg

On the volatility concern that ETFs are leading to higher market volatility, this also is just a myth with little supporting evidence. Below is an interesting chart that overlays the volatility (standard deviation) of the Russell 3000 (a broad US equity index that includes large and small US stocks) with the rising trend of US equity index fund assets as a percentage of all equity funds and you can see there is little relationship of market volatility and rising ETF assets. The volatility is random with noticeable spikes during the tech bubble and financial crisis.

Passive Asset Percentage and Market Volatility

Source: Vanguard

Finally, one criticism of ETFs from active portfolio managers and mutual fund companies is that money flowing into an ETF is driving up stock prices of the largest companies with no regard to valuations and fundamentals of the underlying companies. As I already covered, trading volume of ETFs does not necessarily result in new units being created and money flowing into those underlying stocks. And more importantly, this view presupposes that active portfolio managers have the ability to sniff out undervalued stocks and outperform the market. This is BS. We all know the statistics. Over the last 10 years only 14% of actively managed equity funds outperformed the S&P 500 and only 11% of Canadian equity mutual funds outperformed the TSX.

So their argument that active managers help to keep the market in-check by allocating funds to “undervalued” stocks is without merit. In my opinion, active portfolio managers’ contempt for ETFs has more to do with their declining mutual fund assets and compensation than their actual concerns with market efficiency and stability.

ETFs are the future and offer many advantages to traditional mutual funds. So the next time you see a headline like the one below just disregard and revisit this blog post!

Ryan Lewenza, CFA, CMT is a Partner and Portfolio Manager with Turner Investments, and a Senior Vice President, Private Client Group, of Raymond James Ltd.