Potential Hidden Dangers of ETFs

ETFs have grown in popularity, in fact on a exponential scale, in the past decade or so but even more so in absolute term, after 2010. In the past ten years alone, we experienced an inflow of $1.40 trillion dollars into ETFs products and outflow of $1.20 trillion dollars from mutual funds. ETFs became real popular after 2010 given the increasing popularity of passive investing while offering the diversification and promised liquidity. Side note, passive investing might have some implications on market efficiency but that’s for another post.

• Diversification with ‘liquidity’ – ETFs allows traders and long-term investors to get the diversification they are looking for from the ETFs themselves given that they usually hold a huge variety of companies and also from the amount of ETF varieties the market offers when it comes to acquiring them. There area substantially more #’s of ETFs products vs that of mutual funds out there. ‘Liquidity’ in this case is liquidity for the investors themselves as they can trade ETFs without much restrictions in comparison to mutual funds however…

Promised Liquidity – ETF promised liquidity for the market under the notion that supply/demand and/or selling/buying have more flexibility in that trades can be conducted at a faster pace than mutual funds and other relatively illiquid financial products, which is somewhat true given the redemption challenges and limited selling/buying window. However, this promised liquidity has yet to be tested by the market given that ETFs, is in a sense, the new financial product on the market per Blackrock’s Total Bond ETF asset chart below.

• Vicious Cycle of Demand – Index buyers often times want their products to appear “smarter” or more popular than the other financial products out there to increase demand (which means more inflow to the ETF). One of the more common strategy is to incrementally add the Apple’s and Amazon’s of the world, often times, without taking the more reasonable priced equity on the market. Bear in mind I am not hammering Apple or Amazon, given their respective cash balance sheet and sector diversification, respectively but I am looking at this purely from the functionality of financial market POV. The index buyers will continue to increase their positions in these popular companies while putting less emphasis on the financial bottom line, and as a result, artificially inflate the demand/price of the underlying equity. Furthermore…
• Distorted Market Pricing – This might fuel further distortion in market pricing as the popular tech stocks such as Facebook, Amazon, Apple, Netflix and Google account for an overwhelming % of the gain given their heavier weight in the index. Pair this with the last point might paint another interesting picture. Side note investor appetite for risk has been grow in that they are willing to get Netflix’s $1.30B Eurobond offering for just 3.625% interest rate, for a company that’s rated under Moody’s B1 and burning through $1.80B of free cash flow and growing. Also the major shift in investment for content creation for the media (hard to classify nowadays as Facebook also has their own TV shows now, which by the way, has pushed out some really good content as a active viewer myself).

Just as some blamed the popularity of collateralized mortgage obligations (CMOs) had caused the 2008 US housing crash (Canadian and Australian housing market is going sideways/slight downhill right now but obviously on a smaller scale in terms of global market size), will the popularity ETFs exasperate the downside? Just with any new financial products, no one knows the real downside risks until it is tested by the upcoming economic slowdown. Bear in mind I am not predicting there will be a market downtown nor am I saying they won’t happen soon, I am just looking at this from a pure economic functionality perspective. Two top-level things, as far as what is observed on the market right now in Sept 2017, which makes this short-term cycle different than the Great Recession:

1. Majority of big market players have turn on the alarm sound and have voiced the need to increase % of cash holding in their portfolio. This point alone indicates the decline perhaps won’t be as bad as the Great Recession, a time most big players were not prepared for. This is looking purely from the amount of capital controlled and cash balance in relation to the total market and the “surprise” factor is a lot lower given this moment in time. However…
2. With the QE happening all across the world and now tightening of credit availability soon might create an interesting scenario in which the inflated bond market, inflated relatively to its risk that is (i.e. Netflix sold a B1 Moody rated bond at just 3.625% all which burning through $1.80B free cash flow), paired along with shrinking credit availability, which will pressure commercial and non-commercial credit. Last time, it was housing, a substantial portion of US GDP and economic growth @ ~20-30% but this time, hopefully the government bond market won’t implode and create a domino affect and/or vice versa.

Let me know what you think in the comment/PM.