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Will ETFs cause the next stock market crash?

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Are you overpaying for a company simply because it’s in a ETF? Peter Switzer and Paul Rickard dig deeper.



Peter:    Hello and welcome to Switzer Investing Insights, brought to you by nabtrade.

Peter:    And today we want to talk about a very interesting topic brought up by a guy by the name of Michael Burry. Famous for the book, The Big Short, famous for The Big Short of CDOs, collateral debt obligations, which triggered the GFC and the stock market crash that happened.

Peter:    So, the big question is will ETFs cause the next stock market crash, Paul?

Paul:      Well let's look at some of those concerns Peter and we'll come back to Burry in a moment. But the first thing, just talk about the index tracking ETFs. There's over $5 trillion globally invested in these index tracking ETFs.

Peter:    Huge growth.

Paul:      And in the US at the moment, they're now as big as active investing. This chart from Morningstar shows the growth of passive management versus active management. Passive management and active management in 2018, almost the same. And you know, probably in 2019 if you just trended that chart a bit forward, there'd be maybe the passive would have overtaken. So it's now a absolutely huge industry in the way fund managers invest.

Paul:      Burry is one of many people that have sort of been citing concerns. He's talked about bubbles, he's saying the longer it goes on, the worse the crash will be. Another well-known CEO from DoubleLine has called it a herding behaviour. So there are a lot of sort of concerns from sort of prominent market participants.

Paul:      Let's look, actually, look at some of the actual specific concerns. The first one is about price discovery and what Burry is saying here is that because ETFs buy a whole lot of stocks at whatever the price is, there's no actual price discovery. That is when buyers and sellers are trying to work out what a company is really worth.

Peter:    Yeah.

Paul:      And risk is not being accurately priced. That means that people can over pay for a company simply because it's in an ETF.

Peter:    Yeah.

Paul:      Because an ETF needs to buy, maybe paying a lot more than the company is really worth or conversely, so.

Peter:    And I think adds to the volatility on the way up and on the way down.

Paul:      Yeah, so that's the first point.

      Paul:      And then secondly, he's saying that there's a whole lot of money tied up in these index tracking ETFs actually indexed to stocks with low liquidity. So take for example, the most well-known index in the world, the S&P 500, you can get the S&P 500 here through IVV. But he says that of the 500 stocks that make up the S&P 500, 266 have daily liquidity of less than $150 million per day. But yet there's sort of trillions of dollars riding on the ETF in what are arguably relatively less liquid stocks.

Peter:    Yeah.

Paul:      So if the ETF needs to be unwound and needs to sell those stocks, there's not a lot of liquidity. So he says that that's an issue.

Paul:      Thirdly, he says there's a lot of derivatives now around ETFs and their use of structured assets that could make it worse.

Paul:      And then finally, there's some concerns around so-called sovereign risk or perhaps a unnatural owners. And the example quoted here is that for example with Japanese equity ETFs, the Japanese government owns about 80% of all Japanese equity.

Peter:    So there's a lot of unknowns there, aren't there?

Paul:      There are some unknowns.

Paul:      So let's actually put that in context. I mean first of all, I think in fairness to Burry, he's perhaps arguably talking his book a little bit.

Peter:    Yeah.

Paul:      He is a small cap fund manager.

Peter:    He's an active fund manager.

Paul:      An active fund manager. So he's got a bit of an ax to grind.

Paul:      So let's look at what he said. Are ETFs likely to cause or trigger a crash? I think that's pretty unlikely. I think we can rule that out.

Paul:      I think it's possible that ETFs could exacerbate a correction-

Peter:    Yeah, I agree with that.

Paul:      That is if the market starts to go down and investors out there are saying, "I'm also worried about my holdings." They want to get out of their ETFs. ETFs have to sell stocks. They could actually push the market down. Now that actually happens on the way up as well.

Peter: And also fund managers have to sell too-

Paul:      Yeah.

Peter:    When their clients want to get out. So it's not as though this is going to be the first time ever there's going to be a wholesale selling from fund managers, there's just more passive ones.

Paul:      Now the way that that doesn't become too big an issue is that in that sort of scenario, likely that the bid and offer spread on the ETF would widen. Now ETFs use market makers to help keep the ETF trading in a very narrow price relative to what it's really worth, a so called NTA. That's great in a tight, normal, low volatile market. In a more volatile market, those spreads will tend to widen and they actually will stop some of the selling. So that actually could be in some ways a bit of a perverse positive.

Paul:      The minute that you want to get out, you're going to be probably selling at a price below NTA, but it will actually stop some of the selling.

Paul:      I think that the bigger impact on sort of ETFs in a bit of a crash type scenario will be on small cap stocks simply because they are low liquidity and the ETFs do have to unwind. We could get some big swings in prices there.

Peter:    But of course that creates buying opportunities for hedge fund managers and people like that who see ridiculously low prices on good stocks or be it small caps, and that can be an offsetting effect. But I do agree the volatility increases both ways with ETFs.

Paul:      I think if you are worried about ETFs, and I'm not suggesting you should be, but I think that still the same thing applies in all these markets.

Paul:      Always stick to ETFs on the major ETFs, particularly those with really good and strong underlying issuers.

Peter:    Yeah.

Paul:      Stick to those which have got benchmark indices that are well understood and respected by the market.

Peter:    By the ASX 200 or the S&P 500 indexes.

Paul:      Yeah.

Paul:      And then I always caution this, don't invest in synthetic or exotic ETFs

Peter:    Unless you're a thrill seeker.

Paul:      Unless you're a thrill seeker. And some of the synthetic ETFs or where they're using futures that are then tied to some underlying stocks or you're one or two steps removed from the market. There are a lot of ETFs in the US on all sorts of things. We don't have them here in Australia quite to the same extent, but I think in a market liquidity crunch, they could be tested.

Paul:      So again, stick to the trust and true, the proven names, those high better quality issuers.

Peter:    Yeah.

Peter:    Yeah, I largely agree with what Paul was saying. I do think ETFs will increase the volatility in both ways over the market. But I will make it a point that Ray Dalio, one of the greatest investors in the world, he buys ETFs as well.

Peter:    That's Switzer Investing Insights, brought you by nab trade. Thanks for joining us.