ETFs to make the difference in a market crash

Tuesday’s unexpected drop is a classic example of a volatile market that can sell off on the slightest trigger.

Our next sharemarket crash will be different. It’s going to concern a generation of new investors in Exchange Traded Funds (ETFs) and they have never seen blood on the floor.

A sharp 2 per cent drop on the sharemarket on Tuesday will remind long term share investors just how exceptional returns have been in recent months. But for ETF investors, any downturn of any magnitude might well be a first time experience.

The local Exchange Traded Fund market has mushroomed in the late period of an extended bull market, which had brought returns so far this year beyond 20 per cent. (Exchange Traded Funds are share market listed funds that can mirror an underlying index such as Australia’s S&P/ASX 200 or the Dow Jones Industrial Average in the US).

As the market moved up, money has moved into Exchange Traded Funds at a dramatic rate.

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A report published on Tuesday by ETF Securities said a stunning $17bn went into local ETFs in the year-to-date, lifting the total assets from $40bn to $57bn.

It’s just been too easy for too long. This year’s 20 per cent index returns contrasts with a long-term average that is less than half that number, not to mention periods when the index has gone backwards.

Tuesday’s unexpected drop is a classic example of a volatile market that can sell off on the slightest trigger.

The fall brought the ASX down to 6710. At that level, the market has instantly rolled back under recent records and worryingly, back below the pre-GFC “all-time” high of 6828, which took 12 years to transcend in the first place.

For ETF investors, it’s a pointed reminder that they are strapped to these index movements in good times and bad.

The bulk of that $16bn flowing into ETFs is into locally listed funds that specialise in offshore markets, where returns in key markets such as the US have also been close to 20 per cent.

However, Credit Suisse, the investment bank, has just issued its global sharemarket forecast for the year suggesting “single-digit returns” will be the order of the day in 2020 as “limited earnings growth” sober the action of market traders.

There is already strong evidence that active managers are taking bigger more concentrated bets in order to distinguish themselves from ETFs.

Separately, local brokers putting out their forecasts for the ASX are publishing broadly similar forecasts: a return of perhaps 10 per cent.

But the reality is that brokers invariably suggest the year ahead will do “high single digits” and history suggests those forecasts can be dismissed if the sharemarket enters a serious sell-off.

Traditional “active” fund managers will be hoping a tougher market overall will make the investment public reconsider the fees-based stock picking model that dominated prior to the popularity of ETFs.

There is already strong evidence that active managers are taking bigger more concentrated bets in order to distinguish themselves from ETFs.

New figures from Morningstar for the US market indicate the number of US funds “concentrating”, or holding less than 35 stocks, has doubled over the past decade.

But there is little evidence “concentration” in itself leads to better returns.

“Some conviction funds do well, others do not,” said Michael Malseed, associate director at Morningstar Australia.

One thing is clear though. When a major correction arrives, ETF investors will not just feel an unfamiliar pain, they will be part of a machine that accelerates the trend.

There are widespread fears ETFs will somehow spur a market downturn.

Such fears are misplaced, but ETFs will mirror the action on centre stage.

If we get a serious downturn, they will only make it worse by automatically joining the sell-off.