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Active managers should cut complaints about ETFs

This is the first of a series on the global rise of exchange traded funds

The supposed death of the stock picker has become one of the dominant narratives of post-crisis finance.

As trillions of dollars have rushed into low maintenance, index-based products facilitated by exchange traded funds, it has become common place to hear traditional fund managers and analysts complain that this wall of cash is making it increasingly tricky for them to practice their craft. Some have warned of ETFs and their ilk being bubble machines that funnel vast sums of money into the same trades. Others have even argued that passive investment is resulting in a breakdown of the ability of financial markets to price assets and efficiently allocate capital.

Such unease is understandable. Over the past 10 years assets invested in US exchange traded products tracking everything from the S&P 500 to global uranium miners has risen from $300bn to more than $2tn. This has fundamentally altered the nature of the world’s largest equity capital market, with more than a quarter of all daily trading volume in the US now being made up by ETFs, according to Cantor Fitzgerald, one of the industry’s largest market makers.

Yet it appears that many of the professional investors decrying the rise of the ETF have failed to identify the irony in their complaints: that those who live and die on their ability to exploit market distortions and mispriced assets are so troubled by products they argue are creating exactly the type of distortions they aim to profit from. The rise of the exchange traded fund, far from resulting in the death of the discretionary investor, may, in fact, present an increasingly fecund environment to find undervalued securities.

Market inefficiencies created by ETFs are frequently discussed in terms of tiny arbitrage opportunities between these products and their underlying components that are ironed out across milliseconds by high-frequency trading firms. No traditional human investor can compete against these type of traders on their own terms and as such would be foolhardy to bother. Instead the style of active investor who is most likely to benefit from ever larger chunks of the global equity markets being bought up by exchange traded products are those who are focused on fundamental, bottom-up securities valuation.

Rules-based investment vehicles invariably create forced buyers and sellers. Many of the complaints of active managers about the rise of passive investment products have been based around the idea that they provide a permanent bid for any stock contained within them, and mean stocks that are too small or illiquid to be included are left behind. The low fees charged by exchange traded funds mean they must operate on scale.

This, in turn, means that there are compelling business reasons for an ETF to be designed with the ability to grow to a large enough asset base to be profitable. Equities-based ETFs of all types need to contain stocks of companies that are large and liquid enough to allow them to grow to the required size, meaning the industry is structurally biased towards focusing on large capitalisation stocks and against smaller illiquid companies.

Research by Horizon Kinetics, a New York-based hedge fund, has shown that the correlation of the largest members of the S&P 500 to the index itself has significantly increased over the past 20 years.

The correlation of shares in ExxonMobil with the index has increased from 0.35 in 1995 to 0.73 in 2015. AT&T shares’ correlation has risen from 0.42 to 0.71 over the same period while the correlation of Proctor and Gamble shares has jumped from 0.36 to 0.73. This, the hedge fund argues, could indicate that the increased amount of money devoted to tracking the index is causing its constituents to move in line with one another, meaning those seeking to profit from buying good companies and selling bad ones are finding life increasingly difficult.

There is also some evidence to suggest that certain sectors have started to suffer from a growing valuation gap between larger capitalisation stocks that are included in numerous ETFs and companies that are less accessible to these sorts of funds as a result of their limited free float. Simon Property Group, a dominant component of many US Real Estate Investment Trust ETFs, trades at a significant valuation premium to Dream Unlimited, which is far smaller and has more than 30 per cent of its share capital not freely traded on the market. If this effect is genuine it should be a boon to the traditional value investor.

Whether broad-based index funds or other ETF products do distort the valuations of their underlying constituent stocks is a matter of debate. What does appear fairly uncontroversial, however, is that any stock that is not suitable to be included in an ETF will have less and less possible buyers as more money moves into these sorts of products.

This, combined with the reduction in the amount of sellside investment analysts, should provide opportunities to patient investors who anchor their decisions to fundamental business analysis, and are happy to hold positions for long periods of time. Active fund managers should not despair at the idea that the buying power of ETFs may be destroying their ability to pick between stocks. Instead their struggling profession should view the rapidly changing structure of financial markets as an opportunity.

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