When Passive Investing Turns Active, Make Sure You’re Ready

0 | By Shah Gilani

The whole idea of passive investing – investors tracking the market by owning index funds – has been turned on its head by exchange-traded funds (ETFs).

Most ETFs are index funds, but the investors in them have become anything but passive. Active ETF trading has become the new passive investing, which makes ETFs potential financial weapons of mass destruction.

I’ve been warning my readers about the dangers of ETFs for years. ETFs can lead to a crash when so-called passive investors turn active, as they have been doing lately.

Barron’s front-page story on Monday morning about John C. Bogle, the father of passive investing through mutual funds, got me riled up. It’s a good summation of some of the problems with index ETFs, as Bogle sees it, but it doesn’t go into the weeds at all.

Active traders turn ETFs into dangerous entities for passive investors, but there’s a way to protect yourself from their chaos…

Forty Years of Growing Influence

The index fund universe, both mutual funds and ETFs, is gigantic.

Since John Bogle launched the first passive index-tracking mutual fund at Vanguard 500 Index Investor (Nasdaq:VFINX) in 1976, some $7 trillion is now invested in funds that don’t have a manager but are constructed to track indexes.

Index funds account for 43% of all funds, and they are expected to top 50% by 2021.

Investors have sunk, for the time being, $3.4 trillion into ETFs.

ETFs, which trade like stocks, offer far greater liquidity than mutual funds that are bought and sold based on their closing price or net asset value. Net asset value (NAV for short) is determined after the close of the market between 4:00pm-6:00pm.

NAVs can be calculated all day, and some mutual funds and some pricing services offer intraday NAV calculations. However, transactions on mutual funds occur after the close at the then-determined NAV.

Generally, fees on mutual funds have been higher than fees on ETFs, though many mutual fund families have reduced fees on index funds to compete with ETFs.

Even where fees are comparable, ETFs, because of the ability to buy and sell them all day long, and because many of them offer options contracts, have been overtaking the once-almost-exclusive territory commanded by the likes of Vanguard and others that offer index products.

By their nature, index ETFs are cheap and have tremendous liquidity. Not only do newly minted passive investors prefer them, but ETFs are excellent trading vehicles for traders of all stripes. As hedging products, they’re in high demand because they allow investors to tailor their defensive positioning easily.

But the advantage that index ETFs have over mutual funds also makes them controversial – and potentially dangerous.

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The Weight of the World on Their Shoulders

What’s increasingly controversial about index ETFs, and also true of index mutual funds, is most funds have big capitalization, or “big-cap,” stocks in them. Those big-cap stocks, which have a prominent place in their respective indexes, have to be bought in increasing amounts by ETF sponsors and mutual funds to maintain their same relative weighting in derivative products.

That means their stock prices are better supported, which increases their value, the weight they have in indexes, and all of the derivative products that hold them. This creates a kind of momentum driver that pumps up already-giant companies’ equity valuations.

For example, Microsoft Corp. (NasdaqGS:MSFT) alone represents 3.2% of the S&P 500. Apple Inc. (NasdaqGS:AAPL) is 4% of the S&P. Alphabet Inc. (NasdaqGS:GOOGL) is 3.1%.

Apple’s also in the Dow Jones Industrials Average, where it’s weighting in that index is 5.19%, and Microsoft’s weighting in the Dow is 2.68%. The Boeing Co. (NYSE:BA) is the Dow’s weightiest at 9.79%, versus its 0.84% in the S&P 500.

One side effect of this phenomenon is these big-cap stocks get bigger at the expense of other stocks that aren’t in indexes or don’t have nearly as big of a weighting. They drive big stocks higher, which lifts the indexes they’re in and may distort the actual health of the broad market.

Another controversy over stocks in index funds is fund sponsors and mutual funds own shares. Individual investors don’t get to vote on corporate governance as shareholders. That’s because most funds are set up as trusts, and while shareholders of funds are the beneficiaries of appreciation and dividend payments, trustees holding assets get to vote the shares.

Vanguard, State Street Corp. (NYSE:STT), and BlackRock Inc. (NYSE:BLK) together control 83% of funds where they get to vote the shares.

The biggest problem with so many assets sitting in so-called passive funds, especially ETFs, is what could happen if passive investors turn active and dump their index funds beyond the already-high turnover rate index funds see.

Already, the biggest 100 index ETFs see annual turnover of 785%. That’s mostly the result of short-term traders maneuvering in and out of funds like the SPDR S&P 500 ETF (NYSEArca:SPY), a result of hedging, and passive investors trying to time the market. In comparison, the largest 100 stocks in the market only see turnover of about 144%.

There’s already a ton of trading in most index funds, so what would happen if thousands – even millions – of mostly passive investors decided to activate their sell buttons?

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ETF’s Four-Step Recipe for Chaos

First, it would probably start with a general market selloff. If that turned into a panic and masses of passive investors (especially in ETF products) started selling, several frightening things could happen – all of which could easily get out of control:

  1. As ETF shareholders sell their index products, the heavily weighted big-cap names are sold in proportionately larger numbers. As they have more influence on the indexes they’re in on the way up, they’ll have the opposite negative influence on the way down.
  1. As investors in the big-cap stocks see the share prices that they chased up when momentum buying drove them to (thanks to ETF inflows) suddenly start to see them come down, they’ll start selling them. They’ll take profits and short them, putting more pressure on those names.
  1. As shareholders sell their ETFs, those sell orders are followed by “authorized participants” – the trading desks that fund sponsors hire to create units of ETFs (a creation unit is 50,000 shares) and to unwind them as sellers reduce the need to hold underlying shares in trust. Those trading desks aren’t going to wait for sell orders to come in, knowing they’re going to have to liquidate underlying shares in ETF trusts and accumulate potential losses as they have to sell underlying shares when prices continue to fall. They’re going to short the underlying shares to make a profit on them, and later cover their shorts with the shares they buy from liquidating ETF shareholders. Aggressive shorting by authorized participants will push down underlying stocks, hitting the prices of ETF shares, causing more selling by ETF shareholders.
  1. The cascade of these events, occurring on top of each other, each trying to get ahead, would cause a devastating negative feedback loop.

That’s what’s at the bottom of the ETF swamp.

On Friday, I’ll tell you how I recommend trading index ETFs, how to see a negative feedback loop in the making, and how to profit from it when it comes.

And it’s coming.

Before I go, I want to be real with you for a moment.

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