Given the strong growth in exchange traded funds (ETFs) in recent years – both globally and in Australia – it’s natural for many of the entrenched interests in the once cosy world of active funds management to cast dispersions to the extent they can.
Many like to portray ETFs as somehow complex and risky – when in reality nothing could be further from the truth, given many are just passive transparent vehicles that simply invest in stocks we already know and love and can be directly bought and sold on open exchanges like the ASX.
Going the other way, others try to claim ETFs are too simple – allowing “dumb money” to invest in stocks without regard to their underlying value. Again, the reality is that even relatively simple forms of indexing – such as weighting stocks by their market capitalisation – have been shown to consistently outperform most discretionary “bottom-up” value managers in any case, suggesting it’s not such a dumb way to go. What’s more, there are even smarter ways to index cheaply and effectively – such as fundamental indexing we use at BetaShares – which can generate even stronger outperformance.
But the rearguard action by ETF haters continues. Next in the line of alleged evils is the argument that ETFs are creating a “passive investment bubble” – which is seeing a flood of investors come into the market drive up stock valuations to crazy levels.
One aspect of this argument is correct – we are seeing a flood of investors into ETFs around the word. This really is a revolution in the funds management industry which is shaking its very foundations – but all for the better of end-investors.
According to data from the Investment Company Institute (ICI), for example, between 2007 and 2016, flows into passively managed US equity ETFs and other unlisted passive funds were a staggering $1.4 trillion. In Australia, funds under management within ETFs (or more broadly exchange traded products or ETPs) has leapt from around $1.2 billion in 2007 to almost $35 billion today.
But here’s the rub: this move into ETFs still remains largely a switch from other forms of holding equity market exposure. It’s far from obvious there’s been a net increase in overall investor market participation and in turn bubbly valuations.
The ICI, for example, also note that actively managed US domestic equity funds experienced a net outflow of $US 1.1 trillion since 2007.
It’s also far from clear investors are as yet overly bullish. According to the well established American Association of Individual Investors (AAII) survey of investor optimism, around 45% are currently “bullish” about the outlook over the next six months, which remains in its historical range and still below previous peak levels.
AAII Sentiment Survey
Source: AAII. Weekly survey results. Bold blue line is 20-day moving average.
As for valuations, it’s true that price to earnings valuations in many markets across the world are at above average levels – but they are still far from extreme, and largely justified (in my view) by the still very low level of global interest rates and the increasingly synchronised picked in global economic growth and corporate earnings. As seen in the chart below, for example, the forward earnings yield on the MSCI global equity index remains around 6% – which is a healthy 4.5% premium on the still very low 1.5% yield on the Bloomberg Global Aggregate Bond Index.
Global Equity to Bond Yield Gap
Source: Bloomberg, BetaShares
Last but not least, it’s important to put the growth in ETFs in perspective – they are as yet hardly taking over the world. According to BlackRock calculation, the combined value of equity and bond ETFs globally is around $US17 trillion, or still only around 10% of the market valuations across both these huge markets.
In Australia, the total value of Australian equity ETFs is still less than 1% of the Australian share market’s total capitalisation.
Of course, the rise in equity markets in recent years has been associated with growing demand for ETFs – but correlation does not imply causation, given the other positive macro forces that have been pushing up markets.
And given they are now more prevalent, it’s also likely we’ll see more selling of ETFs during the next inevitable market downturn – just as we’ll also still see the usual degree of selling of directly held shares.