October market fall sparks debate over index ETFs

While the index ETF market has grown strongly in Australia over the past few years, the sector has always had its sceptics. In the past week Zenith has published a review of smart beta ETFs questioning their ability to produce “persistent outperformance”, and investment manager Roger Montgomery has released a paper calling index ETFs “a transmission mechanism for a tech stock bubble”.

Zenith says there is no evidence of “persistent outperformance” among smart beta strategies and questions whether investors and being adequately compensated for making the “active choice” of a smart beta ETF.

Online investment adviser Stockspot, which recommends that its clients use ETFs, struck back in a newsletter last week, saying there was no evidence that active funds did a better job of protecting investors when markets sold off.

Zenith says global index proliferation now means that in some equity markets there are “considerably more investable indices than there are listed equities”.

“Many newer ETPs boast indices that deliver materially different outcomes than their older and broader peers,” the researcher says.

Investors increasingly need to make active choices regarding their passive investments. If an investor decides to employ an approach that is not seeking to capture a broad-based or market cap weighted exposure, Zenith believes the investor is effectively expressing an active stance.

Such strategies raise several questions, such as what unintended consequences can arise.

Zenith looked at whether investors have been adequately compensated by electing to pursue smart beta ETFs. It analysed each ETF’s excess return relative to an investable index-based strategy. It used the Vanguard Australian Shares Index ETF and the Vanguard International Shares Index Fund for its comparisons.

It found that “persistent outperformance is less of an outcome than cyclicality”.

According to Montgomery, the chief investment officer of Montgomery Investment Management, index ETFs are a bubble that are in turn a transmission mechanism for a tech stock bubble

“In late 2018, we are at a fork in the road where investors may want to reconsider their strategies. The trillions of dollars flowing into ETFs peaked in March and we’re starting to see tech stocks return to earth,” Montgomery says.

“The FAANG stocks, which include the likes of Amazon, Facebook and Google, lost a combined US$127.7 billion in value in October alone.

“Many investors in ETFs that follow indexes are as exposed as those who bought collateralised debt obligations before the GFC.

“As the nine-year bull market has progressed, we have seen United States index fund investors become overdependent on a hyper-narrow band of technology stocks.

“Today we stand on a precipice – the investment universe has not seen so much capital concentrated in a single sector that, through convenient products, can be sold at the click of a mouse.”

Montgomery argues that the proportion of the US equity market’s high returns that have been delivered by a handful of mega-cap stocks is historically unprecedented. As index ETFs have grown, they have been forced to invest ever greater amounts in these larger companies, irrespective of price or profit outlook.

“The stock turnover of the major US index ETFs has been significantly higher than the turnover of even their largest holdings. This would lead to a combination of high returns and low volatility on the way up, but the reverse would be true when investors begin exiting,” he says

“We now appear to be at a fork in the road. There will be over-reactions as higher quality tech companies are thrown out with the proverbial bath water.”

While the S&P 500 grew 331 per cent in the nine years since the low of 2009, Amazon was up 2100 per cent, Apple more than 1100 per cent, Netflix 5300 per cent and Google 586 per cent. Adding Facebook, Microsoft and NVIDIA to that list, seven stocks accounted for more than 15 per cent of the entire S&P 500 and just shy of 50 per cent of the Nasdaq 100.

As recently as July, Netflix traded at a price-earnings ratio of 201 times. Only a few weeks ago Amazon was on a PE multiple of 156 times.

Stockspot cites the work of Rui Dai, an analyst at Wharton Research, who analysed fund performance in the US and found that between 2007 and 2009, when the market fell 50.2 per cent, the average active fund fell by 49.7 per cent.

In the tech wreck of 2000 to 2002, when the market fell 43.4 per cent, the average active fud lost 43.2 per cent. In the falls of 2015 and 2016 the typical active fund did worse than the market.