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ETFs: Could they cause the next financial crisis?
The unprecedented
growth ETFs might present significant risks to the capital markets. Are you exposed?
Understanding ETFs
An Exchange Traded Fund (ETF) is a fund that owns underlying assets (shares of stocks, bonds, oil futures, gold bars, foreign currency, etc.) and divides ownership of those assets into shares. ETFs experience price changes throughout the day as they are bought and sold (unlike mutual funds which are only priced once, at the end of the trading day). They typically have higher daily liquidity and lower fees than mutual fund shares, making them an attractive option for individual investors.
The Rapid Growth of ETFs
A decade ago, exchange traded funds were barely on investors' radars.
But since then, the ETF industry has exploded. Investors have poured money into ETFs because they are an easy and low cost way to invest in the underlying assets. And since stocks have been rising for so long --- stock ETFs, especially, have been excellent investments ---
ETFs have become mainstream.
Growth has come both in terms of dollars invested (see chart at right) and the number of funds offered. Today, ETFs exist for virtually every imaginable asset class, sector, and investment style. Are you bullish on cloud computing? There's an ETF for that. Want to align your investments with your religious beliefs? There's an ETF for that. Think there's profit to be made from the growth in professional sports leagues, but don't have the cash to become a team owner? Try the ETF.
Since 2008, the value of the global ETF market has ballooned by five times reaching over $4 trillion today.
Alarm Bells?
With such rapid growth, there is fear that ETFs have created their own bubble-like momentum. As ETF returns have beaten traditional active managers, more money has gone into them. As more money goes in, the price rises. Those rising values attract more money, and so on.
The massive increase in the size of the ETF market has prompted concern among some well-known money managers.
Howard Marks, co-founder of Oaktree Capital, writes in a
memo: "As a product of the last several years, ETFs' promise of liquidity has yet to be tested in a major bear market, particularly in less-liquid fields like high yield bonds."
On stage at a conference, Mohamed El-Erian, Allianz chief economic advisor, and former co-CEO of PIMCO,
warned: "Risk has become embedded into the system as to the proliferation of instruments that look extremely attractive, because they are very cheap
--- ETFs
--- but are overpromising liquidity in inherently illiquid asset classes...It is a huge risk of contagion. People are forced to do things they don't want to do, and the next thing you know the real economy is at risk."
So What Do We Recommend?
Although the resilience of ETFs has not yet been tested by significant market hardship, we believe
the low cost and broad diversification that ETFs provide continue to make them attractive in some sectors. In US and global equities (which are very liquid markets) ETFs are an excellent investment vehicle. But don't be fooled: they will experience the same volatility as individual stocks when markets turn south. For that reason, it is important to limit your stock exposure to a level of risk you can comfortably afford and tolerate.
However, we do not recommend ETFs for fixed income investments, nor do we advocate for passive fixed income investing in general. First, the bond market is massive --- a representative basket of bonds does not actually exist. The ETF manager (and the passive bond mutual fund manager) must make an active decision on how to define 'the bond market'. Second, because ETFs trade throughout the day, during periods of market pressure, the ETF manager may be forced to sell illiquid bonds regardless of the price they can get. Finally, active bond managers can take advantage of market dislocations to actually buy bonds that are under pressure, adding long-term value to your portfolio. We believe in active bond management.
We have similar concerns about ETFs in non-traditional sectors. The more esoteric and illiquid the investment space, the greater price pressure ETFs will experience in bear markets. In most non-traditional sectors, active management (with the right manager) has been shown to significantly outperform passive alternatives. We use our research, extensive manager due diligence and access to institutional-quality managers to position our clients with active managers in these areas.
Please contact us if you are concerned about your exposure to ETFs, or seek advice on active management of your fixed income or non-traditional investments.
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Stocks continued their advance last week, marking the fifth consecutive weekly gain for the large-cap Dow Jones Industrial Average and S&P 500 Index. Only the small cap Russell 2000 lagged slightly from the week prior, but it still enjoys a double digit gain on the year.
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> Inflation:
The newly-released Fed Policy meeting minutes from September reveal a lively debate around inflation, and highlight how inflation may be the key driver of Fed policy over the next year. To get a clearer idea of what participants were looking at, the graph below shows three key measures of inflation. CPI and PCE both focus on inflation as experienced by consumers. PPI looks at prices for all sellers of goods and services, not just final products purchased by consumers.
Both CPI and PPI have held above 2% for extended periods since the start of 2014, although they are currently lower. PCE
--- the Fed's preferred inflation measure
--- however, has remained stubbornly below 2% over the entire period.
An additional rate hike in December remains on the table as the Fed continues to try to slowly remove accommodative policy, letting the economy stand on its own two feet.
> Black Monday:
The 30th anniversary of the event now known as Black Monday is tomorrow. On October 19, 1987, stock markets around the world crashed, shedding huge value in a short period of time. The Dow Jones Industrial Average fell 23% in one day. As awful as that day was in the memory of traders and money managers at the time, the overall economy was barely affected and growth actually increased throughout 1987 and 1988, with the DJIA regaining its pre-crash closing high in early 1989. (Yet another reminder that "time-in" the market is a better strategy than "timing" the market).
Since that time, regulators have overhauled trade-clearing protocols and developed new rules, known colloquially as circuit breakers, which allow exchanges to temporarily halt trading during exceptionally large price declines.
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Joel Holland, a retired firefighter from Sumner, Washington, was crowned the Pumpkin King at the Safeway World Championship Pumpkin Weigh-Off in Northern California this week.
Holland set a new American record with his 2,363-pound mega-gourd. It was Holland's seventh win at the annual competition. He took home $7 per pound, earning him a grand total of $16,541!
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New Market Wealth Management offers modern investment solutions backed by extensive research and experience serving the needs of wealthy families. Through our strategic partnership with
Cliffwater LLC
, we have access to institutional-quality research, investment due diligence and asset allocation tools. We believe this level of experience and unique access to in-depth, sophisticated research are essential for success in today's complex world markets.
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