If you’re an investor, you’re probably aware of exchange traded funds, better known as ETFs. Every bull market in stocks creates new wonder sectors. In the 1990s, it was tech stocks, and the mutual funds that invested in them. Back then, it was an article of faith that you couldn’t go wrong with tech stocks, all the way until the Dot-com bust took them down in spectacular fashion. Is the current bull market repeating the same pattern, but with a different sector? If so, ETF’s could be a parallel false security. As it turns out, ETFs aren’t risk free.
I know I sometimes write like a doom and gloomer when it comes to investing. A few weeks ago I wrote Why the Safe Withdrawal Rate Won’t Work for Most Retirees, challenging another Wall Street article of faith. But the way I see it, Wall Street is increasingly resembling a popular bar on a Saturday night. Investors are drunk on perpetually rising prices. And just as popular bars need designated drivers, I proudly assume that role with investing and retirement.
But it turns out my concerns about ETFs aren’t unique. A couple of weeks ago The Motley Fool ran an article on what I think is an increasingly worrisome trend. In The Hidden Index Bubble they warned that the ETF phenomenon may not end well for investors.
That’s a topic we need to discuss in some detail. Millions of investors have their money primarily invested in ETFs. Like tech stock mutual funds in the 1990s, it’s certain they don’t understand the risks they’re taking on.
Why People Invest in ETFs
Let’s start with the definition. Investopedia defines an ETF as follows:
“…a marketable security that tracks an index, a commodity, bonds, or a basket of assets like an index fund. Unlike mutual funds, an ETF trades like a common stock on a stock exchange. ETFs experience price changes throughout the day as they are bought and sold. ETFs typically have higher daily liquidity and lower fees than mutual fund shares, making them an attractive alternative for individual investors.”
While ETF’s are often confused with mutual funds (in a prime example of how investors don’t always know what they’re investing in), they’re actually completely different animals.
Mutual funds are generally what’s known as actively managed. That is, they’re run by a fund manager who actively seeks out stocks that are likely to outperform the market.
ETFs are based on market indexes. For example, a popular index is the S&P 500 index. Rather than selecting individual stocks to invest in, the ETF buys the entire index. That is, the fund will contain a proportionate share of each company in the S&P 500 index.
ETFs have become popular because they take the guesswork out of stock selection. It avoids the need to pick stocks at all, and enables you to invest in an entire market.
It’s easy to see why ETFs have grown so popular:
- They’re a perfectly passive investment, you’re simply invested in the market.
- Because they’re passive, they generate little in the way of taxable capital gains income.
- Based on the underlying index, they rarely trade stocks, which causes ETF fees to be much lower than those of mutual funds.
- You can invest in a market sector, like high-tech or healthcare, without having to choose individual stocks.
So what’s not to love about ETF’s?
The Professionals Are in on the Act Too
It’s not just individual investors who have fallen for ETFs. Many investment professionals and advisors recommend them strongly. It makes the professional investment manager’s job easier. They can concern themselves strictly with portfolio allocation, and completely ignore the tedious work of selecting individual stocks.
An outgrowth of the ETF phenomenon has been robo-advisors. This development started with popular independent robos, like Betterment and Wealthfront. Today virtually every major investment brokerage firm has their own robo-advisor edition. And as is the case with ETFs, investors are also flocking to robo-advisors.
ETFs work perfectly with robo-advisors too. Robos are based on Modern Portfolio Theory, or MPT. That’s a theory that stresses asset allocation over individual security selection. (I also suspect it adds a touch of white coat scientific research to investing, which has always been far more art than science.)
ETFs fit perfectly within the passive, automated asset allocation-only format of robo-advisors. The robo determines your risk tolerance, then builds a custom portfolio usually comprised entirely of between six and 20 different ETFs. Each ETF represents an asset class. One could be the general US stock market, another can be large-cap stocks, while others hold mid-cap stocks, small-cap stocks, foreign developed nation stocks, emerging nation stocks, US government securities, US corporate bonds, municipal bonds, and foreign bonds.
By investing in a single ETF for each asset class, the robo-advisor can provide a completely diversified portfolio by investing in just a handful funds.
Absent the need to select individual securities, and trade them when necessary, the robo-advisor is able to deliver a professionally managed, fully diversified, low-cost investment portfolio to investors of all sizes.
So far, so good. And that’s the problem.
The ETF Risk No One Talks About
In a comment on the safe withdrawal article linked at the beginning of this post, reader/investor/fellow blogger Ian Bond quoted Mike Tyson’s brilliant saying, “Everyone has a plan until they’re punched in the nose.”
That perfectly sums up my suspicions about why ETFs aren’t risk free. ETFs are a fairly recent phenomenon. The first one rolled out in 1993 – just 25 years ago. But there’s another interesting parallel. A super bull market in stocks ignited in 1982, and but for three brief stock market crashes along the way, it’s been an elevator ride straight up for 36 years.
Question: Would ETFs be so popular in a much less predictable market?
In the steady kind of market increases we’ve seen since 1982, ETF’s are the perfect investment vehicle. You invest your money, and “ride it out” through thick and thin. But thin has been in short supply. That’s been especially true since 2009, when the market has not sustained more than a 10% reversal in nine years.
The kind of market that we’ve been in for 36 years – which most investment experts assume to be permanent – is perfectly suited to ETFs. No stock selection is necessary. Just invest in markets, push the UP button, and ride the elevator to higher stock prices.
But if prices begin to fall in a sustained pattern – which we’re overdue for – or merely move sideways for a decade or more, stock picking is likely to come back into vogue.
It’s easy to invest in markets when those markets rise predictably. But when they start misbehaving, the elevator will start to go down for everyone on it. When that happens, picking strong stocks will be the only strategy left.
WARNING: ETFs reek of the kind of complacency that doesn’t work in unstable markets.
How Hidden ETF Risks Could Hurt Small Investors
If the ETF phenomenon reverses course, the obvious outcome is that small investors will get clobbered. If the decline is particularly severe, or lasts for many years, small investors will be driven from the market. In doing so, they will have locked in permanent losses. The sheer number of small investors invested in ETFs means millions could exit the market, never to return.
Here’s the point: ETFs are only effective in predictably rising markets. My guess is most people who are invested in ETFs believe they’re safe. And why shouldn’t they think that? The investment community has clearly implied as much. They’re safer than individual stocks, safer than mutual funds – heck, they’re practically government bonds.
Except that they’re not.
Here are the basic flaws of ETF’s that small investors are hardly aware of:
- Even though they’re ultimately comprised of stocks, ETFs are actually investments in markets, not individual stocks.
- Stock valuation doesn’t matter, since individual stocks don’t matter.
- Stocks rise in price not because of fundamental strength, but because ETF money flows indiscriminately into the market.
- The above situation inevitably results in stocks having unsustainable valuations.
- The typical small investor has no idea what he or she is investing in with ETFs.
I’m not predicting a market crash anytime soon. In fact I’m on record in predicting the Dow will break 30,000 before this run is over. But watch out when it ends.
Index Funds Aren’t as Diversified as We Commonly Think
The S&P 500 – that means you’re invested in 500 different companies. That sounds pretty safe, doesn’t it?
But maybe it really isn’t.
The Motley Fool article points out another important development. The index funds ETFs are based on are weighted by market capitalization. That is, the actual investment mix in the S&P 500 favors the largest companies in the index based on the total market value of their stock.
They break down S&P 500 allocations this way:
- 13.3% of the index is comprised of just the five largest stocks by market capitalization.
- The 10 largest stocks make up 21%.
- The 25 largest stocks make up 31.1%.
In other words, index-based ETF investing means the rich get richer.
An ETF based on the S&P 500 then is not as diversified as we like to think. But even more significant is that index-based investing can drive the valuations of the largest stocks to absurd levels.
I’d also add a fundamental psychological component to the ETF phenomenon. When confidence in an investment strategy grows to the point where no one questions it, disaster isn’t far away.
What Could Tip the ETF Apple Cart
At the risk of sounding overly simplistic, the ETF phenomenon will continue until it doesn’t.
But what can prick the bubble of this seemingly perfect investment universe? Answer: anything that will derail the stock market in general.
The thing is, ETF’s are just another way to invest in the stock market. They don’t represent some sort of investment brave new world. They have their nuances, certainly when compared to mutual funds. But they don’t alter the overall risk involved in stock market investing.
That’s also part of the problem by itself. Investment trends like ETFs cause small investors to believe the stock market is less risky than it really is. And when too many people believe that, trouble starts.
The ETF phenomenon is not some sort of specific bubble that will burst on its own. It’s merely a subset of the general stock market. And when that goes down, it will take ETFs with it – the confident assurances of the investment community notwithstanding.
Anything that can bring the stock market down will also torpedo ETFs. It’s anyone’s guess how that will play out specifically.
My best guess is that will have something to do with a dramatic rise in interest rates. It’s no coincidence that the super bull market in stocks began in 1982. That’s the same year that a long-term trend in declining interest rates began.
Interest Rates are Pivotal
Look at the following chart (courtesy of the St. Louis Fed). It shows the history of the yield on the US 5-year Treasury Note, going back to 1962.
The rate topped out at over 16% in 1981. At that time stocks were in a prolonged 15-year bear market that began in 1966. By the end of 1982, the rate drifted down to just over 10%, a decline from the peak of more than six percentage points. It was during that rate decline in the second half of 1982 that the stock market began its 36-year super bull run.
By early 2009, at the end of the Financial Meltdown, the 5-year note yield had fallen below 2%. It continued to drift lower until it fell well below 1% in 2013. It has since increased to 2.75% as of July of this year. That’s considerably higher than the bottom in 2013, but still at Great Depression-era levels or even below.
It’s clear the bull market in stocks has paralleled the steady decline and prolonged flattening out of interest rates.
But what happens when the interest rate trend reverses?
Stock market “experts” like to downplay the centrality of interest rates in the investment picture. But interest-bearing investments compete with stocks for investor’s money.
If you can get 10% on a CD, you probably won’t to invest in stocks. After all, CD interest is guaranteed, stock gains are not.
But when interest rates on those same CDs is 2%, investors are pouring into stocks. I think that explains the latest iteration of the super bull market, certainly since 2009.
What would cause interest rates to rise dramatically? Certainly not these occasional but much heralded quarter-point hikes in the Fed funds rate by the Federal Reserve. Those are mostly for window dressing, and they don’t have the effect on interest rates we tend to think. And closer to the truth, the Fed isn’t going to raise rates to any level that causes problems in the stock market.
That also helps to explain why interest rates continue to be near historic lows, despite a supposedly booming economy. In a truly market-driven economy, current debt levels would drive interest rates much higher than they are right now. Instead, they remain at artificial lows.
What would cause a legitimate and prolonged spike in interest rates?
The most obvious reason is loan defaults. At very low rates of interest, debt of all kinds has been increasing dramatically in recent years. Defaults could be the result of a weakening economy, or simply too much debt, or combination of both.
And when that happens, and interest rates rise legitimately, the stock market will look like the high risk venture it’s always been.
Until that happens, we’ll continue to play let’s pretend everything is really that great. But once the interest rate dam breaks, the cold reality will be what were we thinking?
When ETFs Aren’t Risk Free Plays Out – Protecting Yourself from the Fallout
The obvious answer is the lower your faith level in ETFs. And it should follow that you should also lower your exposure to them. That doesn’t mean you should dump all your ETFs. But ending further investment is certainly a reasonable strategy.
Don’t assume the ETF success of the past nine years will continue into the future. A declining or unstable market will be unkind to ETFs and to those who invest in them. Stock valuations and picking fundamentally strong companies will come back into favor.
It might help to pay close attention to the actively managed mutual funds that have been performing best since 2009. That’s not a guarantee of future success, but it is a strong indication.
In the meantime, it will help to gradually shift your portfolio from all ETFs into safer assets, like money markets, CDs, and very short-term bonds (less than five years). Exactly when this bubble will burst is anyone’s guess. In the meantime, the best strategy may be to “keep your powder dry”. That means loading up on cash and cash equivalents, and sitting tight until a new trend emerges.
The bottom line is this: ETFs don’t remove the fundamental risk involved in stocks – they only mask it. The stock market has gone straight up in the past nine years, and since ETF investing has grown during that time, the natural assumption is that ETFs are less risky investments.
That theory is unlikely to survive the test of time, and it’s best to be prepared when it happens.
Are you heavily invested in ETFs? Do you assume they’re less risky than stocks or mutual funds? If so, why?