No big short on the ETF boom

‘Big Short’ hero Mark Burry has taken aim at exchange-traded funds ... but this time he’s got it wrong.

Each time in history when the market has fallen, including most recently 2000 and 2008, active managers performed on par with the index.

The hero of the Big Short, Michael Burry, has placed exchange-traded funds on his watch list. The collective groan from the ETF industry was audible. It’s no coincidence that those most threatened by ETFs and index investing are also its most vocal opponents.

Despite this, S&P Dow Jones estimates that indexing has saved investors $US287bn in fees since 1996.

Here are the most common myths peddled about ETFs and indexing and why Burry is wrong.

Indexing makes all shares move together

ETF managers do not “pick” stocks and therefore cannot set share prices. Rather, they buy the companies within an index at their relative “market weights”.

They have no influence over what shares come in or out of an index. All of that is determined by active buyers and sellers.

This year AMP shares have fallen 20 per cent while CSL shares have risen 30 per cent. Money coming into index funds would buy both of these shares but would take the prices set by active investors.

ETFs don’t actively buy and sell often, so they only contribute a small amount of the overall trading volume, in most of the world it’s less than 5 per cent of volume and even in the US trading by indexed funds only accounts for about 15 per cent of volume.

Indexing is the idiot’s guide to investing

A stockbroker recently told me that “buy and hold indexing is dumb” and their clients were much more sophisticated because they “traded often”. However, an active investor trades on the assumption they’re better informed than participants. An ETF investor benefits from the prices determined by active investors who are taking bets against each other.

Investing is one of the few places in life where the evidence shows that the more you do, the less you get. For 30 years the DALBAR research group has shown that people who make fewer decisions, both advised and unadvised, earn higher returns.

A more likely reason value fund managers have done poorly over the past 10 years is too many value fund managers.

Indexing is a market bubble

Booms and busts are not caused by indexing, it is the herd mentality of investors chasing or leaving markets. Markets have gone through booms and busts since the start of time due to economics, governments, wars, monetary policy and a whole host of other factors.

There have always been sectors of the sharemarket which have shown incredible volatility. In the 1630s it was Dutch tulip mania, in 1720 the South Sea bubble and in the 1970s there was the infamous minerals boom led by Poseidon in Australia. The largest flow of funds into US tech shares ever occurred in 1999. This was well before indexing fully evolved yet there was no shortage of active fund managers eager to buy tech stocks at the peak.

Indexing misprices shares

This rumour seems to originate from fund managers who have underperformed and are looking to excuse their poor performance. Index funds cop the blame for causing the shares they own to be ignored and undervalued.

ETFs cannot influence prices in any meaningful way. Moreover, if indexing did cause shares to be mispriced this would create opportunities for active investors to beat the market. Active fund managers would be celebrating, not bemoaning indexing.

Active funds protect you when markets fall

Each time in history when the market has fallen, including most recently 2000 and 2008, active managers performed on par with the index. There’s a good reason for this: for every active investor who beats the market, there’s one who hasn’t. Active investing is a zero-sum game versus the index. Investors in actively managed funds are in aggregate certain to underperform the market by the fees charged by these funds in both rising and falling markets ­because active investors are the market.

As more money goes into indexing it gets harder to beat the market because the less capable active fund managers are weeded out.

Indexing could cause everyone to sprint for the exit when markets are stressed

Human nature applies equally to active and index funds. If more people want to sell than buy, both active and index investors are affected equally. In any event, indexed funds still only comprise two per cent of the Australian sharemarket. It’s strange that some people think it’s a bad thing money is moving out of active funds that have high costs, high turnover, poor performance and are tax inefficient into indexing and ETFs which have lower costs, are more tax efficient and perform better as a whole.

Indexing is also easier to understand and more transparent.

The rapid growth of index investing and ETFs is here to stay and reflects the “deflating” of the active investing boom of the 1980s to early 2000s.

There is one group you won’t hear complain about low-cost index funds and ETFs — the people who invest in them.

Chris Brycki is the CEO of investment adviser www.stockspot.com.au which is not an ETF issuer but advises clients to invest in diversified portfolios of low-cost ETFs