Rising Risks of ETFs

Rising Risk of ETFs


Executive Summary:

The Wolves of Wall Street


“Wide diversification is only required when investors do not understand what they are doing.”

Warren Buffett 


It seems like the only investment advise you hear nowadays in the financial industry is “diversification”. Just remember that back in 2008 these same assholes pitching us about diversification lead us directly into the worst financial crisis since the Great Depression. Exchange Traded Funds (ETFs) are all the rage on Wall Street right now and retail investors have taken the bait. An ETF is an actively traded financial product that provides instant diversification into a basket of stocks designed to mimic an index like the S&P 500. There is a consistent trend towards over-diversifying as it is supposedly safer. But is it really?


Wolf of Wall Street Diversify


Portfolio diversification is being taught to all MBA students and financial industry professionals as part of Modern Portfolio Theory (MPT). MPT was created by an economist named Harry Markowitz back in 1952, which ultimately won him a Nobel Prize (kudos). MPT is based on the Efficient Market Hypothesis (EMH), which basically states that the market is efficient and that asset prices reflect all publicly available information; therefore all stocks theoretically reflect fair value. The ETF industry was created to incorporate the values derived from MPT and EMH. The problem, however, is that economic theory is far different than what actually happens in practice.


Dancing With Fire


The current wave of investors mindlessly plowing money into ETFs to gain access to a diversified equity portfolio has been quite dramatic, see below.


Passive versus active fund flows



Don’t get me wrong, ETFs can be a cost effective and efficient tool for many people who don’t have the time or desire to properly research individual stocks. Lackluster performance in the mutual fund industry hasn’t helped active investment managers much either. A lot of firms were charging high fees and were basically just copying the S&P 500 Index (closet indexers). These factors have lead to investors ditching active fund managers for ETFs, which is logical. However, the inherent irony in ETF investing is that the more people that buy into it, the more inefficient the market gets.



The Financial Times has a great article on it here, but the skinny is that stocks being picked up by an index are disproportionately overvalued, while stocks being left out of an index are more likely to be undervalued. This happens due to the mechanics of how ETFs function. Most major ETFs are structured as a market-cap-weighted index, which means that the larger companies have a higher allocation in the index while smaller companies account for a smaller percentage. Straight from the ETF mothership (a.k.a Vanguard), here’s an explanation on why ETFs are market-cap-weighted indexes. Basically what happens is that as investors plow money into these ETFs, the money goes towards stocks that have the largest market-cap, which makes large company stock prices go higher. As more money continues to flow into the fund, a disproportionate amount of that money will continue to go towards those large-cap stocks, driving a divergence between price and underlying stock values. Company fundamentals are not taken into account. Companies that produce negative cash flow and a lot of debt can still receive a higher allocation of funds than companies that actually make money. Stocks that are excluded from the index are treated as roadkill. These factors will eventually be a tailwind for individual stock pickers who take advantage of these inefficiencies in the market.


The BOJ and Moby Dick


In a normal market environment ETFs can be great for most people. The problem is that we are not living in a normal economic environment. Central banks around the world have injected incredible amounts of liquidity into our financial system. The Bank of Japan has even gone to the extreme measure of directly buying ETFs! 


Bank of Japan ETF whale



The Japanese government owns over 60% of the Japan ETF market as of June of 2016, and that data is about a year-old. Pretty incredible stuff. At the end of the day this is really just financial engineering in action, and from prior experience that usually doesn’t end well (remember asset backed securities?). Just to give you a more in-depth picture of the BOJs impact on companies through buying ETFs, see chart below.


Bank of Japan dominates shareholder ranking


This is obviously more on the extreme side, and luckily for my fellow Americans out there Uncle Sam/Janet Yellen isn’t that crazy…….yet. The main takeaway here is that the Japanese government has taken what retail investors have been doing, which is blindly plowing money into ETFs, and putting it on steroids. This is part of the economic policies of Japanese Prime Minister Shinzō Abe referred to as Abenomics.


Abenomics cartoon

Food For Thought


Just to be clear, I’m not saying that the popularity in ETFs will lead us into another financial crisis, but I do think that a lot of people are blindly buying these instruments without understanding the true implications of their actions. Most in the personal finance community clearly promote ETF investing to diversify and automate their investment decisions and recommend utilizing robo-advisors to achieve this. Stocks, like any other investment, ultimately come down to price and its relative relationship with valuation. Sure, you can get away with buying high flying assets like tech stocks back in 2000 or the market as a whole back in 2007, but eventually the punch bowl gets taken away. It happens every time. When that happens the retail investors, a.k.a the average Joe’s in the world, always receive brunt of it. ETFs can be an important element to help grow your finances, but make sure you know exactly what you’re buying and the risks associated with it.


As a value investor, I make money from being a contrarian. When stocks fly high to absurd levels, I sit back and build cash while the party music is on full blast. When the music stops, and everyone is rushing for the exits, that’s when its time to go to work picking up stocks for dirt cheap since everyone else, who just got burned financially, are too scared to act. In regards to getting burned, a popular quote that is passed around in the value investing circular from Mark Twain. It serves as a reminder to all the “great” financial products in the past that were sold by Wall Street and the new products being sold to your average Joe, which usually doesn’t have a happy ending.


“History does not repeat itself, but it often rhymes.”

Mark Twain