We have spilt much ink here over the last 6 months talking about the rise of ETF’s and the passive investing strategies that utilize them. Our primary concern has been to ensure that our readers KNOW what’s in their ETFs and how those ETF instruments are structured (physical vs. synthetic index replication, etc.). This stuff is important because it has everything to do with the actual RISK in the fund and the investor’s probability of capital loss.
This week the Financial Times has been running a series this week on the Age of the ETF.
In this specific piece the author, Miles Johnson, makes some very well reasoned points why active investors should be cheering the rise of ETF investment. Interestingly, he quotes ETF market research from Horizon Kinetics, that we have reviewed here previously to make some of his assertions.
You will remember from our previous posts on the topic that we strongly believe that too much of a good thing is, indeed, a bad thing and that the piling of assets into ETF’s is likely to lead to imbalances and structural market cracks (systemic risks arising predominantly from synthetic replication strategies). While this is likely the case, there may be a silver lining for folks like IOI who believe that BOTH active and passive strategies should play a role in modern portfolio designs.
Mr. Johnson makes this point as follows:
- “Instead the style of active investor who is most likely to benefit from ever larger chunks of the global equity markets being bought up by exchange traded products are those who are focused on fundamental, bottom-up securities valuation.”
- “What does appear fairly uncontroversial, however, is that any stock that is not suitable to be included in an ETF will have less and less possible buyers as more money moves into these sorts of products. This, combined with the reduction in the amount of sellside investment analysts, should provide opportunities to patient investors who anchor their decisions to fundamental business analysis, and are happy to hold positions for long periods of time.”
The article does a good job of outlining ETF structures as a bit of background as well as running through again the conclusions from the Horizon Kinetics research that you’ve been exposed to.
This is worth thinking about and may begin to influence some of the stock choices we make in our focus Tear Sheet, ChartBook and Guided Tear Sheets. If indeed ETF’s are influencing correlations which would artificially confound price discovery, that is something to be very concerned about indeed.