Howard Marks (Trades, Portfolio) has made a successful career appkying a highly active approach to value investing -- buying the debt of distressed companies, applying rigorous analysis in his screening of stocks, and so on. So it should come as no surprise that the investor has some reservations about the widespread use of exchange-traded funds and passive investment strategies, as he outlined in an interview several months ago.
On ETFs and silver bullets
“ETFs are just another investment technique. And like all the others they have feet of clay. When I was a kid, we watched the Lone Ranger, and his gun fired silver bullets and he never missed. And everybody in the investment business is always looking for the next silver bullet, and people on the sell side promise it to them. There is no such thing as a silver bullet; there’s nothing that delivers high returns without risk. The question is - it’s just an investment technique - do people expect more from it than can be delivered, and is that going to be a source of disappointment and will that be an important factor in cracking the market?"
Marks is not necessarily saying that ETFs can’t be a legitimate tool for investors to use, but what he is saying is that the investing public has developed unreasonable expectations as to the long-term success of these vehicles. He went on to make the point that investors have a false sense of security with regards to the liquidity of their ETF holdings:
“No investment vehicle can, in tough times, be more liquid than the underlying. So, for example, we have high-yield ETFs which people assume they can sell any minute, but they know that if they had a portfolio of high-yield bonds it would take them some time to work out. So they think that the ETF is much more liquid than the underlying: where does that increment in liquidity come from? And the answer is: in tough times it will be shown to be illusory, in my opinion.”
At the end of the day, an ETF is just a tool, and it can function well, or it can function poorly, depending on the circumstances at hand, and to place blind trust in one specific tool is foolhardy. As Marks puts it: “The only thing that really can be depended on in the investment world to work is superior judgement, not any technique or algorithm.”
On the bubble in passive investing
“There’s certainly been a trend to it [the bubble] ... I have a feeling they’re [passive investors] expecting too much … Merely saying that I would rather own stocks in an ETF indirectly or in a mutual fund, is not necessarily wrong. As long as you understand that if the market has a hiccup, your ETF will get hurt and you may not be able to get out so close to the last price as you thought. Now, the one thing that probably should be highlighted about ETFs is that a conspicuous number of ETFs are concentrated in the same stocks, because many of them use momentum as a factor, momentum favours a relatively short list of stocks and the movement of money into ETFs which feature those particular stocks certainly has contributed to the increases in the prices of those stocks relative to other stocks.”
There are two main issues that come with such a flooding of capital into passive investment vehicles. First, investors can get complacent about the security of their investment -- in a scenario like the dot-com crash many people would find it difficult to liquidate their holdings at a price close to where the sell-off began.
Second, the expansion in passive investing has driven up the stock prices of a narrow group of stocks -- chiefly, the FAANGs. Because the most common passive investing strategies are market cap-weighted, this creates a self-perpetuating cycle where more and more people pile into these glamor stocks as they grow in size. This cannot go on forever, and at a certain point the music will stop. When that happens, many passive investors may find themselves unable to unwind their positions.
Disclosure: The author owns no stocks mentioned.
