ETFs are fast becoming Wall Street’s most controversial instrument. As passive investing continues to gain weight among investors, the use of ETFs by retail investors and traders to bet on certain instruments to which they may not be able to obtain direct exposure is rapidly increasing. As the number of ETF users grows, the chorus of experts warning against their increasing dominance is getting ever louder.
ETF use exploding
The numbers behind the ETF boom are nothing short of astounding. Last year, investors added a total of $282 billion to ETFs, a record figure, surpassing the previous annual all-time high of $244 billion set in 2014. At the same time, investors withdrew hundreds of billions of dollars from actively managed mutual funds. High fees, poor performance and the low cost of beta are reasons generally given for the shift from active to passive.
Seth Klarman (Trades, Portfolio), one of the world’s most respected value investors, weighed in on the rise of the ETF in his year-end letter to investors. Klarman noted that the rise of the ETF may only lead to more opportunities for the enterprising value investor – of which I’ve written about before at GuruFocus.
Specifically, Klarman notes that ETF activity tends to result in overpriced securities remaining overpriced, and underpriced securities becoming even more underpriced as ETFs ignore those sections of the market that fall outside their investment mandates. Ironically this will eventually result in a situation where those investors who have bought into the efficient market dream by investing in ETFs are all ultimately making the market more inefficient as funds are concentrated in certain sections of the market.
Opportunities abound
For value investors, these developments could present some great opportunities. Misunderstood or illiquid stocks will never find themselves in ETFs. Therefore, they will continue to be neglected by the market. This means there is a greater likelihood that a mispricing will exist and persist.
What’s more, ETFs can’t include these instruments even if they wanted to. ETFs are designed to be highly liquid and will only be profitable instruments if they can grow to enormous size. Investing in small-cap illiquid equities will never give ETFs the size they need for providers to make a profit. Also, reweighing a portfolio of illiquid stocks on a daily basis leads to severe market dislocations.
More volatility
However, while the rise of the ETF could be a good thing for value investors, it is widely believed that a prevalence of ETF trading will result in more market volatility. According to John Bogle, founder and retired CEO of Vanguard, the average turnover for an ETF is 880% per annum, compared to just 12% for a standard stock.
As a result, if investors rush to get in or out of an ETF the instrument may struggle to keep up with the underlying security leading to market swings as the ETF over and undershoots underlying buying. There’s no doubt that this would present a challenge for value investors who don’t have a long-term view.
It is likely that there will be more short-term distractions as ETFs continue to dominate trading. Nonetheless, it is here that the long-term value investor has time on his or her side. Short-term market gyrations will present some attractive opportunities if you can look past near-term volatility.
Time arbitrage is one of the last avenues for alpha of which a value investor can make use; rather than hindering the quest for this alpha creating a market anomaly, ETFs will only increase the number of potential alpha opportunities investors will have available to them.
The bottom line
Overall, even though some of the market’s most respected investors are warning of the dangers of ETFs, it looks as if the product will present some opportunities for value investors over the long term. Put simply, value investors should celebrate, not hate, the rise of the U.K. and the short-term nature of investors the product is inspiring.
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