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Analyst sounds the alarm on the 'most crowded trade in investing history'

ETFs have become the most crowded trade in history. (Flickr / James Cridland)

Steven Bregman, the co-founder and president of Horizon Kinetics, an independent research firm specializing in inefficient markets, sounded the alarm on the exchange-traded funds (ETF) industry.

Speaking at the Grant’s Interest Rate Observer Fall Conference this week, Bregman warned of an “indexation vortex that’s distorted clearing prices in every type of asset in every corner of the globe.”

According to Bregman, the ETF industry has “created a massive systemic risk to everyone who believes they are well-diversified.”

In a presentation entitled “Indexation: Capitalist Tool (Delivery Agent of The Great Bubble),” Bregman gave just a few of his “endless examples” of how major distortions in the market have been created by passive investing that’s been “blindly leading” trillions of dollars.

“It’s created a bifurcated market like no other, which we like to call the ‘ETF divide,’” he said.

ETFs present the risk

Indexation is a “fine” idea, Bregman said, but there’s a “pesky issue” of supply and demand. For Bregman, index mutual funds aren’t really the issue— it’s the index ETFs.

Since 2007, there’s been an exodus from actively manage funds and a march into passively managed indexed equity funds and ETFs. More than $1.1 trillion moved into indexed equities with approximately $730 billion flowing into index domestic equity ETFs and $425 billion into index domestic equity mutual funds. Meanwhile, around $835 billion moved out of actively managed equity mutual funds, Bregman’s presentation noted.

Passively managed equity ETFs have exploded. Note: Bregman did not use this graphic in his presentation. (Image: BofAML)

Basically, since the crisis, market participants have walked away from sector-specific and company specific risk. Instead of buying the individual equities, they’ve put money into bland ETFs.

In 2005, there were only 204 ETFs. By 2015, that number had increased to 1,594 even as the number of listed stocks declined, Bregman noted.

What if ETF trading dries up?

Another point Bregman made is the tremendous amount of annual share turnover in ETFs. He compared an S&P 500 mutual fund to the ETF, noting that the annual shareholder turnover rate for the Vanguard 500 Index Mutual Fund (VFINX) is about 42%, while the SPDR S&P 500 ETF (SPY) is 3,507%.

“That’s nearly 100% per week. That’s a lot of asset allocation. Feel a little bubble?” he said.

He then posed a question of what happens when there’s net-selling? Is there really enough underlying liquidity? Or would the market collapse?”

“That was kind of the tipping point during the technology bubble,” he said. “Is there really enough underlying liquidity? There was a dress rehearsal, I’d say, last year on August 24th, among the interesting features of the market that day, ETFs set an all-time record for share of New York Stock Exchange trading volume of 37%. And that morning prices of more than a few ETFs departed markedly from their [net asset values], which is not supposed to happen in supposedly liquid investments.”

Many ETFs lack proper diversification

Another problem for ETFs is their top-heaviness, which creates an “idiosyncratic risk” for investors who think they’re buying diversified portfolios, Bregman warned.

He used the iShares US Energy ETF (IYE) as an example, noting that the top four holdings — Exxon Mobil (XOM), Chevron Corp (CVX), Schlumberger (SLB), and Occidental Petroleum (OXY) — make up nearly 50% of the fund. Another example he used was iShares MSCI Spain Index ETF (EWP), pointing out that the top 10 companies have a 64% weight in the fund. What’s more is 6 of those top 10 holdings get 70% or more of their revenues from outside of Spain, he explained.

Sometimes, the same handful of stocks will appear in a variety of ETFs promising different kinds of exposures. For instance, Exxon appears simultaneously in value ETFs, growth ETFs, weak dollar ETFs, momentum tilt ETFs, and low volatility ETFs.

“We would do well to remember that this state of affairs is hardly a new phenomenon. In prior eras, it is known as go-go investing or trend following. Now it takes the guise of index-based asset allocation. I’m not aware of any such phenomena having ended other than unpleasantly,” he said.

He continued: “The index universe has simply become a big momentum trade and it’s the most crowded trade, we think, in the history of investing. And crowded trades eventually attract short-sellers. They just need a starting gun.”

The golden age of active management may be coming

Bregman raised an unexpected question: “Are active managers the anomaly, or is the market?

A number of well-known active managers like Mario Gabelli, Bruce Berkowitz, Bill Ackman and Carl Icahn have under-performed in the last couple of years, Bregman’s presentation showed.

“Were they the anomaly? Did they all lose their touch simultaneously? Or was it the S&P 500 that was the anomaly? For some people, that sounds like an outrageous statement?

He said in the beginning of the presentation that when the bubble phase is over he thinks it will “create a golden age for the active value manager.”

There are opportunities out there, but mainstream investments can’t be that place because their prices reflect their utility as liquid trading instruments.

“The beauty of the markets—the market flows in one direction, it has to drain from somewhere else,” he said, noting that there are “idiosyncratic securities” on the other side of the ETF divide that are “relatively invisible.”

These securities are ready for individual inspection and purchase. Investors just have to be willing to take a “touch of illiquidity risk,” which will allow for their freedom and optionality to expand enormously.


Julia La Roche is a finance reporter at Yahoo Finance
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