Bank of America warns investors about the perils of increasing passive exchange-traded funds.
Bank of America Merrill Lynch’s Global Research department warns that the popularity of ETFs may be leading us to liquidity problem. Strategists issued a report stating that “the actual shares available, or true float for S&P 500 stocks, may be grossly overestimated.”
“Historically, large cap US equity managers have had the luxury – and curse – of a liquid, efficient market. On the one hand, capacity has been less of an issue for the S&P 500 than it has been for the Russell 2000, but on the other hand, it is much harder to have an edge on large, well-followed stocks than on smaller, less-followed peers. That liquidity is slowly being called into question by the “ETF-ization” of the S&P 500.”
The number of investors engaged in passive investing has surged, and this is somehow distorting the stock market and destroying the real liquidity of the market. As a result, stocks and the overall market could fluctuate violently to the downside.
Investors are attracted to passively managed ETFs because they get to choose baskets of stocks that represent different parts of the market.
ETFs currently represent almost a quarter of US stock-market trading volume compared to 76 percent for individual stocks. According to report by CNBC, over $4 trillion is now invested in ETFs.
“Investors have increasingly shifted to passive investments: Clients have been net buyers of over $160 billion in ETFs versus net sellers of over $200 billion in single stocks since 2009,” Savita Subramanian, lead strategist at Bank of America Merrill Lynch, said in a report published in TheStreet.
To best illustrate the massive growth of the ETF industry, Vanguard, which is known as one of the biggest issuers of ETFs, has grown its share of the S&P 500 market capitalization to 6.8 percent today. It now has more than 5 percent stake totaling 491 in the S&P 500, compared to only 116 in 2010, the report said.
“The danger is when the market falls. Liquidity will evaporate,” Joe Terranova, chief market strategist for Virtus Investment Partners, told CNBC.
The report also warns investors that ETFs distort price-earnings (PE) ratio. It is recommended that individual investors pursue under-owned parts of the market and buy stocks before ETF managers eat them up when it’s time to rebalance their funds. According to the report, under-owned stocks have outperformed the one that have low price-to-equity ratios in a span of three months.
To demonstrate what an ETF-driven market looks like, the B. of A. report made reference to the Japanese stock market.
The report said that about “70 percent of the assets under management of Japan-focused equity funds is passive—granted, the BoJ has been buying ETFs—and their markets are still functioning.” But the percentage of active funds outperforming Japan’s Tokyo Stock Price Index dropped to 3.4 percent from 2014 to 2016, compared to 46 percent from 2002 to 2013.
Some analysts, however, believe that ETFs provide tremendous advantage to investors, as they allow low-cost and easy access to financial markets. According to Byron Lake, international head of ETFs at J.P. Morgan Asset Management, the growth in ETFs is important in giving investors the opportunity to diversify and mitigate risks.
“Approximately 5,000 ETFs are now available globally compared to over 16,000 mutual funds distributed across Europe and the U.S., so investors have no shortage of choice of opportunities for diversification,” he told MarketWatch.
Josh Brown, CEO of Ritholtz Wealth Management, also added that the markets will always be plagued by liquidity problems “any time the amount of sellers swamps the amount of buyers.”
“ETFs are way more efficient and although there will always be hiccups, the machinery has demonstrated its ability to be extremely durable in times of market stress,” Brown told CNBC.