Monday 14 December 2015

Exchange Traded Funds(ETF’s) : why too much may be dangerous now?


“It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”: Mark Twain

Zara espouses low cost investing as a way to gather assets and it is unlike us to speak out against a perceived low cost option like ETF’s. But let us clarify we are not the first, Warren Buffet has railed against them for some time now. Carl Icahn has added to the debate by calling some of them downright dangerous (only to be proved right by the high yield bond markets).

Firstly, we don’t think ETF’s are a cheap form of investing, when they enable and encourage you to trade every minute and second of the trading day, thus adding to cost of ownership. A simple index fund with a low expense ratio would otherwise be fine for an investor looking to keep his costs low.

Secondly, Investing blindly in indices or a bunch of stocks in the hope of coming out okay is probably the most dangerous activity in the investing world today. Just as any activity carried out to the extreme makes no sense, neither does index following carried out to an extreme. The Nifty Fifty craze (investing in the top 50 companies) of the 1970’s in the United States, is an example of how massive amount of wealth is destroyed, when investors blindly invest in a bunch of stock in pursuit of returns.

Today in a repeat of the 1970’s USA, there is a worldwide proliferation of indexed (including ETF’s) assets under management at the expense of active management. For example of global equity fund assets, approx. two thirds are US raised assets. The ETF market worldwide is also dominated by the US, who has 73% of the global ETF assets garnered. Just 10 years back ETF fund assets  were less than 4% of US fund assets versus ~20% now. In CY14 almost 90% of equity fund net inflows worldwide were through indexed funds. If like the Nifty Fifties of the 1970’s in USA , this fad of index tracking ( possibly causing overvaluation in some market segments) results in a sharp fall in global markets, in this correlated global village, we are sure to be part of the collateral damage (like it has been in the past).

 In India of the approx. USD 300 billion Foreign Institutional Investor (FII) holding in the Indian equity market , approx. 45 % is  through funds that track/ benchmark some index (ETF’s were a decent part of inflows in recent times but are a small part of current overall  FII equity assets in India). FII’s now own ~20% of the market major indices (Sensex/Nifty) and approx. 40% of the floating stock and hence are important participants to track. All this point to the possibility that, stocks that are part of the country indices tracked by these FII funds, may have been bid high or could lack qualities of a good bargain (due to crowding in of investments).

Thirdly, in a market stress situation participants that ensure liquidity find it difficult to value units accurately, hence increase their bid ask spreads or just do not provide bids, increasing the cost of trading ETF’s. In such a situation, even index fund providers may find that every redemption request the industry receives causes steeper price falls. It is also possible some components of the index may not be as liquid as thought earlier, causing issues in redeeming units in the first place, like in the high yield market worldwide today.

Fourthly, many of the ETF’s/ index funds track their indices through synthetic instruments (derived exposures), which expose you not just the market, but also to counter party credit risk and even leverage sometimes.
Finally, for such a complex aggregation of stocks as in various indices it is difficult to quantify risk undertaken in meaningful terms. An investor needs to split up the components of such a complex aggregation of stocks and examine the risks he is actually undertaking, or he may inadvertently end up exposing his portfolio to risks he was unwilling to take in the first place.

Anything taken to an extreme has the potential for disaster. Even healthy eating.
 Gregory L. Jantz, Ph.D.
 
ETF’s and Indexing as a phenomenon may have been taken to extremes in the rapid growth of the last ten years. Also, there is never a given trend in the investing world, any trend carried long enough, makes space for its demise. By now, you get the import; keep your eyes open, invest carefully.

At Zara as you already may know, we believe in long term commitments and see market fluctuations as an opportunity to either sell or buy, keeping value in mind. As such we are not driven by market benchmarks and their movements, but are cognizant of them. Zara believes in advising fund deployment based on fundamentals which include margin of safety, meeting estimated cost of capital, minimising risk to generate reasonable returns across a business cycle of 5 to 7 years.

In your service
Dinesh da Costa, CFA                                                                                                       
Zara Investment Advisory
  
Please note information given above is not a recommendation to invest, but an educational illustration.
Please leave your comments by emailing at dineshd@zarainvestmentadvisory.in  or if you have a Google account by clicking on the link below       


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