ETFs in a Bear Market
Exchange-traded funds (“ETFs”) have enjoyed tremendous growth since the financial crisis. We’ve discussed this growth previously, but as a refresher, the following chart illustrates how passive investment funds have been stealing market share from funds that are managed actively.
Source: Morningstar Direct
If you were an individual investor who decided to switch your entire portfolio from actively-managed funds to passively-managed funds at any point since the recession, you’re looking pretty smart right now. Not only would you have slashed your fees to a fraction of what they were before, but many actively-managed funds have underperformed their benchmark indices on a gross basis as well.
As these benchmark indices went higher and higher, the amount of money being invested in ETFs also increased. The next chart shows that fund flows into passive funds have grown in lockstep with the S&P 500 since 2008. If this relationship is causal, and not pure coincidence, a bear market could have a significant impact on ETF fund flows – and possibly vice-versa.
Source: Morningstar Direct
Individual investors are a notoriously fickle bunch. The following chart illustrates just how emotional their decision-making can be. The orange line shows the previous quarter’s mutual fund returns. The blue line shows net fund flows for these same mutual funds. The high correlation of the two lines suggest that investors are quick to sell their mutual funds after poor performance and buy after good performance.
If this behaviour was to be mirrored by ETF investors during a bear market, the securities within the indices tracked by the ETFs would face disproportionate selling pressure. Would this ETF-driven selling pressure be enough to cause the broad indices to decline more than securities not included in major indices? Nobody knows for sure. But as ETFs continue to own a larger share of public market securities, the risk of them being the catalyst behind the next pullback moves higher.
A shift away from active management to passive management has also raised questions about how market volatility will evolve. We are currently in a period of record-low expected volatility (as measured by the CBOE Volatility Index). If volatility was to increase, the recent growth in ETF assets could amplify the impact.
Analysis by Bank of America Merrill Lynch found that the 100 U.S. stocks with the largest passive ownership have historical volatility of 24.5% versus 20.9% for all stocks. These 100 stocks also realized price declines of up to 30.3%; this compares to 23.7% declines for all other stocks.
Part of the theory for these higher price swings is that ETFs themselves are already traded more frequently than stocks. In 2016, the average ETF had turnover of 880% (i.e., it was held for only 41 days). By comparison, the average stock had a turnover of just 120%. While simply trading an ETF does not require the underlying securities to be traded, net buying/selling of ETFs does require buying/selling of the underlying securities. Thus, if there was widespread ETF selling in a bear market, broad market volatility may be amplified to the downside.
To further illustrate just how large of a role passive investing now plays in the markets, consider current trading volumes. J.P. Morgan estimates that 90% of U.S. trading volume comes from passive and quantitative asset managers. We believe that these type of strategies can amplify market momentum, one way or the other. The flash crash in 2010 comes to mind. As a result, future market crashes with root causes completely disconnected from valuation fundamentals seem increasingly likely.
There are a lot of unanswered questions about what the rapid growth in ETFs means for capital markets over the long-term. The potential risks are significant, and regulators around the world are beginning to take notice. The International Organization of Securities Commissions, SEC, and even Ireland’s central bank have all recently discussed the matter.
Unfortunately, no regulator, like us, has been able to come to any firm conclusions about what the future holds. So the best we can do right now is estimate how our portfolio would be affected by an ETF-driven bear market.
On average, the equities within the Cowan Absolute Return Fund have just a 7% ownership by ETFs. This compares to 18% ETF ownership for the five largest companies in the S&P 500 (according to Bloomberg). While we won’t conclude that this lower ownership percentage means our portfolio is immune from any potential ETF bear market contagion, it does temper our worst fears.
ETF growth is unlikely to slow anytime soon. Low fees combined with markets that continue to climb higher give investors few reasons to question ETF efficacy. But we are in uncharted territory. The ETF boom has never been tested by a prolonged bear market. And with some market valuations near all-time highs – just as central banks are beginning to tighten monetary policy – the next bear market could be coming sooner than some people think.