Most people prefer predictable environments, particularly when it comes to investing. Investors want to be able to develop a view of the markets and how they work, one which they are confident they’ll be able to apply to reduce risk and improve returns, and which is adaptable enough to apply in a wide range of normal market conditions. However, today, what was perceived for decades as “normal market conditions” seems no longer to exist. All professional investors know that the market is always changing, reflecting changing perceptions, fashions, and cycles which inevitably drive stock valuations. Today, in addition to these normal historical changes in fashion and perception, new technological changes created by high frequency trading and ETFs have shifted the investing playing field considerably. Some people believe that these changes have made it much harder for traditional active managers, and that active management will not be able to outperform index investing. The purpose of this note is to show that the perceived superiority of passive, computer-driven indexing is flawed, and also that the market changes caused by these technological shifts actually can create more opportunities for fundamental analysts and active investors to outperform.
Changes In Market Structure
The past 20 or so years have seen a number of these slow-moving but extremely significant structural shifts in global stock markets. Algorithmic and high-frequency trading (HFT) are examples. Many trades are now made by high-frequency and algorithm-driven computer programs. Some investors have responded by doubling down on old strategies; we prefer to acknowledge the new realities and adapt ourselves to them. HFT and Algorithms For most investors, HFT means that computers shave pennies off of each transaction, and deliver those pennies from the pockets of “real” investors to HFT firms, who have no regard for “investing.” HFT computer behaviors can also mean a dramatic increase in volatility or a dramatic evaporation of liquidity at times of severe market stress, which we have seen several times in recent years. The risk of disruption during market panics may be increasing -- which is good for human investors to bear in mind, since there are ways to reap rewards from that volatility. Algorithmic trading, in short, refers to computer-driven trading, which is based on the computer program’s recognition of certain criteria -- and executing trades without the intervention of human emotion, processing, and analysis. This means that the market will behave differently and “feel” different, since many of the traders are no longer human. Old intuitions about market action that hinge on an intimate knowledge of collective psychology -- about the rhythm and pattern of a market correction, for example -- must be relearned when the traders are not humans whose reactions shift in response to a changing environment, but robots who will keep carrying out their program no matter how the market feels to the humans who are still there. And we humans, to adapt, must study the algorithms as if they were a new species, and seek out knowledge of how the algorithms behave -- and of what concerns, views, and strategies the algorithm writers are trying to encode in their robot servants. (We must also realize that algorithms are still quite clumsy compared to human traders, but that they will begin to mimic actual traders more effectively as their creators become more adept.) In summary, as we wrote a few weeks ago in our meditation on artificial intelligence, we remain convinced that the higher faculties of human perception, insight, analysis, and intuition will forever be beyond the reach of algorithmic programming: humans are not machines, and machines are not human. Our flexibility and insight will allow adaptive human traders and investors to succeed even in a market increasingly driven by computers.
Passive Investing, Index Funds, and ETFs
Another enormous structural change in markets during the past two decades has been the rise of passive index investing -- first through mutual funds, and now increasingly through exchange-traded funds (ETFs). This change has slowly transformed the way that stock markets behave, and not all in constructive ways. Nevertheless, the investor’s task is basically not to condemn a change, but to adapt to it, and discover where that change opens new opportunities for profit. Funds that passively track indices arose for good reason. Index mutual funds made diversification less expensive for investors. ETFs added additional benefits. Unlike mutual funds, they trade throughout the day; they’re highly liquid; they can often be sold short to hedge other long positions; and they can allow investors the ability to make rapid asset allocations to target particular industries, markets, countries, or commodities. Although they got their start tracking a few “plain vanilla” indices such as the S&P 500, the Dow Jones, or the Russell 2000, there are now thousands of ETFs tracking an ever-growing array of exotic indices, from cybersecurity companies to the Vietnamese stock market. They are relatively cheap, liquid, and provide investors with flexibility. ETFs’ contribution to overall trading volumes has risen dramatically over the past decade and a half; the annual turnover in ETF shares is now four times the turnover in company shares, according to Bloomberg. Each year, the value of ETF shares traded in the U.S. exceeds U.S. GDP. ETFs now account for a quarter of trading volume on U.S. exchanges. This is up from a near-zero level at the turn of the millennium. The sudden advent of such a phenomenon begs investors (and economists, in fact) to ask questions about its consequences, intended or otherwise.
When we ask those questions and look at the data, we see that ETFs are changing the investment characteristics and behavior of the stocks that underlie them -- increasing volatility, introducing new risks without compensating investors for taking them, and reducing transparency. Through these effects on stocks and stock market participants, they may also be distorting capital markets and hindering the role that these markets have played in the historical dynamism and growth of U.S. capitalism. As before, we make these observations not to criticize or bemoan the development of ETFs, but simply to try to understand the phenomenon so we can determine where and how to profit from it. Like every structural change that has ever come to the stock market, this change offers opportunities from which perceptive active managers can profit.
The Problems ETFs Create Through Financial Engineering Can Be Turned Into Investor Profits
First, many investors have the impression that ETFs are constructed simply: that they’re investment vehicles in which a share represents ownership in a basket of underlying stocks held by the ETF issuer. The reality is often different and significantly more complex. A difficulty faced by an increasing number of ETFs is that they promise liquid daily trading, while the indices they track are comprised of instruments that are illiquid -- so illiquid, in fact, that they could not be traded without significantly affecting their price. This is true for ETFs that track thinly traded foreign markets, for example. The ETF sponsors can get around the difficulty by not holding the components of the index, but rather replicating the performance of the index by entering into complex swap arrangements. These are so-called “synthetic” rather than “physical” exchange-traded products. That ETF May Not Hold What You Think It Does
Source: Bank for International Settlements Working Paper No. 343
The financial engineering underlying these structures may work well under normal market conditions. However, it introduces a critical weakness that is absent from the “plain vanilla” ETF model in which the sponsor holds the underlying instruments, and that weakness iscounterparty risk. The investor who owns the ETF actually owns a share of a derivative instrument, not of a basket of stocks. While under normal conditions that risk may indeed be well-managed, under conditions of severe market stress, counterparty failures may occur -- especially when, for example, the collateral posted by one of the partners to the swap also consists of illiquid instruments. The bottom line is that increasing numbers of ETFs have structures that are extremely opaque in terms of their risk profiles, and investors continue to trade them without being able to accurately evaluate that risk, and without being compensated for it. A fundamentally-minded active manager can keep their clients’ money out of such instruments and avoid the hidden risk they represent.
Other Risks to Investors
An empirical analysis of stock behavior during the rise of index funds and ETFs shows that other risks are rising as well. During daily trading, a “plain vanilla” index ETF such as the SPDR S&P 500 Trust [NYSE: SPY] will create and destroy ETF shares in order to coordinate the ETF share price with the current market values of the underlying stocks. That means that the underlying stocks are all being bought and sold together as a group, which means that intuitively, we would expect their price movements to converge. That’s exactly what the data show. The chart below shows that in the 24 months following inclusion in the S&P index, stocks move from very low price movement correlation with the index to extremely high correlation with the index.
Source: National Bureau of Economic Research Working Paper 16376
This means that in “the new normal,” price movements have less to do with the fundamentals of the company, and more to do with the performance of the index, i.e., with macro factors, market psychology, and algorithmic patterns. The common stock of a company could once have been viewed as reflective of that company’s economic performance. However, once it is incorporated in an influential index, it behaves more like a reflection of that index. Thus the index becomes “the tail that wags the dog.” This is a fundamental shift in market structure that is significant to investors, because once again, it allows fundamental researchers and active investors an opening to profit from ETF “herd psychology,” as we discuss below. The era of index ETFs is not just an era in which price movements become more correlated. Not only are “betas” (measures of stock volatility) converging -- they are also rising across the board. This market-wide rise and convergence in volatility is again exactly what we would intuitively expect; and analysis of the data bears it out.
Equal-Weighted Average Betas for U.S. Stocks: Rising and Converging in the Index ETF Era
Source: Financial Analysts Journal
That rising and converging beta has consequences for investors. Contrary to the common assumption of mainstream asset pricing models, within stock markets, high-risk stocks have, on average, delivered lower returns than low-risk stocks: In the Long Haul, Lower Beta Stocks Deliver the Goods
The Universe of U.S. Stocks Divided Into Quintiles By 60-month Trailing Beta, and the Growth of $1 Invested in Each Quintile
Source: National Bureau of Economic Research Working Paper 16376
Of course, we are not arguing that high-beta stocks are simply to be avoided -- when market conditions are appropriate, we’ve often found tremendous opportunity in high-beta stocks. Rather, we’re commenting on the changing environment. Index ETFs are creating an environment in which risk is higher for all market participants and they are not being compensated for their exposure to that additional incremental risk. The benefits of ETFs are widely proclaimed, but the analysis showing these negative effects is not nearly as widely discussed. Investors who have been won over by passive indexing therefore don’t realize some of the new risks from which active management can help protect them.
Analysis further shows not only that price movements are becoming synchronized among index components, and not only that beta is rising and converging among index components, but, as we would expect, the logical consequence of these changes is also occurring: the correlation between future earnings and current stock returns -- the so-called “future earnings response coefficient” -- is becoming weaker across the board. As we note below, however, when active managers take advantage of ETF “herd behavior” during a downturn to buy individual stocks with good fundamentals, they will be rewarded when the downturn has run its course.
Finally, we want also to note the economic consequences of these changes. Robust capital markets have been one of the pillars of the U.S.business dynamism that we noted last week. However, ETFs are leading to an erosion of the pricing efficiency of these capital markets. That means that incrementally, transformational entrepreneurs will opt to sell their companies rather than go public in an environment where the trend will be for their stock not to be valued on fundamentals and on growth prospects. And when transformational startups are sold to larger businesses rather than going public in their early stages of growth, they will tend not to preserve as much of their transformational culture as they are integrated into a larger and more hidebound organization. As we wrote last week, transformational new businesses are the most important engines of economic growth and job creation in the U.S. economy. So the changes in market structure we’ve identified have an effect beyond their immediate impact on investors -- they also have an incremental effect on the economy itself.
ETF Dislocations Create Potential Benefits for Intelligent Investors
Given that this is the new and different environment in which investors must operate, how can they navigate it and take advantage of it? What potential benefits are there to be gained? First, being aware of the opacity and unrewarded risk of synthetic ETFs, we can be cautious to avoid them, particularly in periods of heightened market-wide risk (such as the present). Or, if not to avoid them entirely, to invest with a light hand. Active managers can make use of them without being trapped by them.
Second, while it’s true that the index ETF era has corresponded with increasing price correlation between stocks and the indices, the level of that correlation is itself volatile on a short-term basis. It tends to spike significantly higher during market corrections, and then turn lower again when the correction is over. In essence, correlations are higher across the board -- but the combination of ETF dynamics and market psychology makes downside correlation higher than upside correlation. An active manager who uses fundamental research to pick stocks and buy them when the herd takes them down, can then reap outsized rewards when the downtrend reverses and the stronger break away from the herd.
Shaded Bands Represent Bear Markets
Source: S&P Dow Jones Indices This divergence offers an opening to patient investors who are committed to fundamental analysis. The lesson that the markets are giving is that while fundamental knowledge about a company is as important as ever, investors must be patient in acquiring that knowledge and ready to deploy it especially during market downturns, when more than ever, the stocks of strong companies are punished along with the stocks of weak companies.
The data are too limited to confirm this hypothesis, but we think it is likely that the “herd behavior” created by the growth of index-tracking ETFs has made this tendency even stronger. If this is correct, the opportunities presented to fundamental analysts who are prepared to take active advantage of market declines will actually be enhanced by the structural changes that ETFs have created.
The rise of passive, index-tracking ETFs and their increasing presence in markets is an unavoidable fact. Contrary to the view of many market participants, though, we believe that the structural changes involved can actually benefit fundamentally-minded active investors -- those who are patient enough and wise enough to buck the trend.
Investment implications: The advent of high-speed and algorithmic trading has brought major changes to the structure of U.S. stock markets to which investors have had to adapt. Another major structural change has been the rapid rise of exchange-traded index funds (ETFs), which have led to closer price movement correlations among stocks, as well as rising and converging volatility in the stock market as a whole. Increasingly, thanks to ETFs, individual stocks seem to be dependent on the index, rather than the index ultimately reflecting the fundamental characteristics of the stocks that comprise it. Rather than view these changes as a negative, however, we see where they actually create opportunities for active managers. The “herding behavior” that ETFs support means that during market downturns, correlations will increase more dramatically, and then decline again when market stress eases. Therefore, active managers who are willing to use careful analysis, intelligence, and above all, patience, can actually benefit by finding stocks at the bargain prices created by the environment that computer-driven trading and ETFs create.
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