====================================
I was at a CFA Baltimore board meeting, and we were talking before the meeting. ?Most of us work for value investors, or, growth-at-a-reasonable-price investors. ?One fellow who has a business model somewhat like mine, commented that all the money was flowing into ETFs which were buying things like Facebook, Amazon and Google, which was distorting the market. ?I made a?comment that something like that was true during the dot-com bubble, though it was direct then, not due to ETFs, and went to a different group of stocks.
Let’s unpack this, starting with ETFs. ?ETFs are becoming a greater proportion of the holders of stocks, and other assets also. ?When do new shares of ETFs get created? ?When it is profitable to do so. ?The shares of the ETF must be worth more than the assets going into the ETF, or new shares will not get created.
It is the opposite for ETFs if their shares get liquidated. That only happens?when it is profitable to do so. ?The shares of the ETF must be worth less?than the assets going out of?the ETF, or shares will not get liquidated.
Is it likely that the growth in ETFs is driving up the price of shares? Not much; all that implies is that people are willing to pay somewhat more for a convenient package of stocks than what they are worth separately. ?Fewer people want to own individual assets, and more like to hold bunches of assets that represent broad ideas. ?Invest in the stock market of a country, a sector, an industry, a factor or a group of them.
The creators and liquidators of ETF shares typically work on a hedged basis. ?They are long whatever is cheaper, and short whatever is more expensive — but on net flat. ?When they have enough size to create or liquidate, they go to the ETF and do that. ?Thus, the actions of the creators/liquidators should not affect prices much. ?Their trading operations have to be top-notch to do this.
(An aside — long-term holders of ETFs get nipped by the creation and liquidation processes, because both diminish the value of the ETF to long-term holders. ?Tax advantages make up some or more than all of the difference, though.)
Does the growth in ETFs change the nature of the stickiness of the holding of the underlying stocks? ?Does it make the stickiness more like a life insurer holding onto a rare “museum piece” bond that they could never replace, or like a day trader trying to clip nickels? ?I think it leans toward less stickiness; my own view of ETF holders is that they fall mostly into two buckets — traders and investors. ?The investors hold a long time; the traders are very short term.
As such, more ETFs owning stocks probably makes the ownership base more short-term. ?ETFs are simple looking investments that mask the underlying complexity of the individual assets. ?There is no necessary connection between a bull market and and growth in ETFs, or vice-versa. ?In any given market cycle there might be a connection, but it doesn’t have to be that way.
ETFs don’t create or retire?shares of underlying stocks or bonds. ?And, the ETFs don’t necessarily create more net demand for the underlying assets. ?Open end mutual fund holders and direct holders shrink and ETFs grow, at least for now. ?That may make a holder base a little more short-term, but it shouldn’t have a big impact on the prices of the underlying assets.
My friend made a common error, confusing primary and secondary markets. ?No money is flowing into the corporations that he mentioned. ?Relative prices are affected by greater willingness to pay a still greater amount for the stock of growthy, highly popular, large companies relative to that of average companies or worse yet, value stocks.
Now the CEOs of companies with overvalued shares may indeed find ways to take advantage of the situation, and issue stock slowly and quietly. ?The same might apply to value stocks, but they would buy back their stock, building value for shareholders that don’t sell out. ?In this example, the secondary markets give pricing signals to companies, and they use it to build value where appropriate — secondary markets leads primary markets here. ?The home run would be that the companies with overvalued shares would buy the companies with undervalued shares, if the companies were related, and it seemed that management could integrate the firms.
What we are seeing today is a shift in relative prices. ?Growth is in, and value is out. ?What we aren’t seeing is the massive capital destruction that took place when seemingly high growth companies were going public during the dot-com bubble, where cash flowed into companies only to get eaten by operational losses. ?There will come a time when the relative price of growth vs value will shift back, and performance will reflect that then. ?It just won’t be as big of a shift as happened in the early 2000s.
Sir, what are the tax advantages of ETFs versus say index funds?
Thank you,
Mike
I don’t think your answer and your friend’s question relate….
I think the question is related to not just ETFs but index funds or all nature, which have obviously increased over the years. For instance, if we take a simple Vanguard SandP500 index fund, which has to match the performance of the SandP500 index, the more money that flows to this fund, the more Vanguard has to buy of the underlying shares of 500 companies. Is this not correct?
Given the dominance in terms of % of certain companies Apple, AMZN, GOOG, etc. because the Vanguard fund is not equal weight, the fund has to buy the same stocks in the same proportion as the money that is flowing in each day/month/year. Therefore, this will bid up the prices of these same stocks more, and then the market cap of these stocks increases more, and they become an even bigger proportion of this SanP500 index…It’s recursive with the more money that keeps flowing in…
I think this is the question your friend is asking, not about the structure of an ETF that has to create and destroy shares each day.
What are your thoughts on the above?
I agree with the other commenter. Your friend is talking about the impact of indexation and low fee funds in general, the mechanics of which necessitate that the funds buy large amounts of the most liquid assets in whatever category they are in. Low funds (as a percentage of assets) require lots of asset gathering to be a successful operating model. A fund that is “open” that creates new shares and buys the underlying bundle with the proceeds, is limited in size by the availability of the least liquid security in the portfolio. So funds that aspire to be big wind up in the same bundle of high cap, highly liquid securities.
All of the funds are therefore selecting *for* the same things and thereby also selecting *against* the same things (smaller and more illiquid things). Since the things that are being selected for are also the primary components of the index, the index outperforms on momentum – AND the index *creates its own momentum*.
But it also means lots of money flowing into the same top-heavy parts of the index.
Small illquid things, by contrast, are being sold as value managers and fundy shops are closing due to years of outperformance by the most expensive things, which are being purchased without respect to underlying value and are being bought en masse. Shorting, which technically possible (you can get a borrow) is nearly suicidal, given the tidal wave of price insensitive buyers.
What will be interesting is what happens when the music stops and the machines start selling. Because while it may be true that shares get repurchased only when they are lower than the value of the basket, it may be VERY VERY hard to find a bid when the big funds have to start liquidating. Liquidity is much harder to find in a sell-off than in a rally.
Yes^ the SPX has turned into a momentum fund. It’s nuts.
And there will be a tidal wave of price-insensitive sellers just looking to stop loss.
I have to admit that I have positioned myself for this. I am long many smaller stocks that are not exposed to the selling likely to happen with liquidating ETFs that are basically receiving margin calls from their investors. I do own a few high quality large cap names but not many. I have been cashing out on some of the very large gains I have made there to provide me with extra cash for the “after deluge sale”.
That having been said, stock gains have been pretty widespread of late, so it may take some time before this bull market becomes a bear.
If you take the combined value of Facebook, Google, Microsoft, Amazon, Apple, and Tesla and calculate the market capitalization weighted P/E ratio (using 100 for Tesla) for the lot, it works out to approximately 53.7. Those companies, combined, have almost 3 trillion dollars in market value — roughly equal to 10% of the US total corporate sector value based on the most recent Z1 data.
So there’s some frothiness in the richest end of the tech sector. It’s not going to zero by any means but the prospects for doubling collective profits from that group seem somewhat unlikely, and absent that maintaining current valuations indefinitely will be challenging. Further, there are approximately 100 private tech unicorns — if the average mark on those is about 5 billion, there is another 500 billion or so of notional corporate value that doesn’t have any earnings attached to it, that may, at some point have to be marked to reflect that.
More interestingly is how quietly housing has reflated (with respect to sales price/median income ratios), the standard issue thesis being that underbuilding in the wake of 2008 led to a deficit in the housing stock. If the census data are correct, then simple extrapolations suggests that the current demographic trends won’t sustain the current level of building (1.15 million annualized using the recent quarterly average completions) given total 20-65 year old population is increasing less than 1 million/year. (One cannot imagine a crackdown on illegal immigration will be of benefit to the population numbers either.)
Both of these seem tomorrow problems however, as neither appear pressingly unsustainable. In a passing conclusion, it’s interesting that we appear to be having more modest versions of both the previous two investment cycles combining. And finally in the interest of disclosure, I am the owner of several of the equities mentioned in this comment.
It seems to me that ETFs are part of a trend of fewer and fewer people actually bothering to look at stocks from a bottom-up perspective. Perhaps an opportunity?
Nick de Peyster
http://undervaluedstocks.info
I think so.