Here’s How Wall Street’s Selling Everyone Tickets on the Hindenburg

This is a syndicated repost courtesy of Money Morning. To view original, click here. Reposted with permission.

Everybody loves exchange-traded funds (ETFs) these days.

There are a mind-boggling 2,000 ETFs, give or take, in the United States today. Roughly 70% of those are equity funds.

The three largest equity ETFs, packed with around 25% of all equity ETF assets, are S&P 500 index funds, like the SPDR S&P 500 ETF Trust.

Now, it’s true that indexing gets most of the investment love at the moment, but there’s a really brisk business in so-called “motif” or “thematic” passive strategies.

These let investors tap into just about any sector or idea that strikes their fancy.

Of course, you can passively invest in exciting sectors like robotics, defense cybersecurity, or biotechnology, but you can also buy ETFs that invest in faith-based or special-value principles, like veganism (I’m serious) and animal welfare, or social justice.

Essentially, here in the weird year 2018, if an investor can fathom it, there is an ETF that can be created to allow for one-click investing in the idea.

But ultimately, most of the money is flowing into the large-cap indexes.

After all, indexing is the new pet rock/Rubik’s Cube/Beanie Baby, and, as such, is the answer to all our investing prayers.

Everybody loves exchange-traded funds (ETFs) these days.

There are a mind-boggling 2,000 ETFs, give or take, in the United States today. Roughly 70% of those are equity funds.

The three largest equity ETFs, packed with around 25% of all equity ETF assets, are S&P 500 index funds, like the SPDR S&P 500 ETF Trust (NYSE Arca: SPY).

Now, it’s true that indexing gets most of the investment love at the moment, but there’s a really brisk business in so-called “motif” or “thematic” passive strategies.

These let investors tap into just about any sector or idea that strikes their fancy.

Of course, you can passively invest in exciting sectors like robotics, defense cybersecurity, or biotechnology, but you can also buy ETFs that invest based on faith-based or special-value principles, like veganism (I’m serious) and animal welfare, or social justice.

Essentially, here in the weird year 2018, if an investor can fathom it, there is an ETF that can be created to allow for one-click investing in the idea.

But ultimately, most of the money is flowing into the large-cap indexes.

After all, indexing is the new pet rock/Rubik’s Cube/Beanie Baby, and, as such, is the answer to all our investing prayers.

Wall Street is embracing the idea that the unmanaged indexes will usually outperform the highly paid active managers.

Faced with the prospect of collecting low fees, or worse, no fees, even the old-school brokerage and investment management firms are pushing the idea of low-cost index funds to their clients.

It is the ultimate solution (to a problem nobody really has). Like party drugs, nobody can get enough of these things.

Well, when (not if) the market turns and the sun comes up on the carnage, it’s going to be much worse than anyone ever realized…

Here’s What Mark Twain Would Say…

Mark Twain

Ah, the snake oil and silver bullet hucksters of Wall Street and their sweet, seductive siren song…

They’ve made ETFs, and especially equity ETFs, the gospel of the day. To hear them tell it, you would argue with it at your own dire peril.

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Owning index ETFs will give you high returns with little risk. They’ll make your teeth whiter, knock inches off your waistline, and help grow back the hair you started losing a decade ago, too.

Passive investing is the “ultimate solution” today, in much the same way that the “Nifty Fifty” was in the seventies, or selling index puts was in the eighties, or dot-com stocks were in the nineties, or residential real estate in the early aughts.

Everyone and their sister knows it to be so.

But…

Whenever I find that everyone knows something, I stop and think about Mark Twain before I join the herd. Twain once suggested, “Whenever you find that you are on the side of the majority, it is time to pause and reflect.”

Well, upon deeper reflection, I find two giant, horrible problems with ETFs and passive investing that make me think that just maaaaaybe they’re not the perfect “ultimate solution” investment after all.

People Have a Dangerous Blind Spot for ETFs

Chief among the many problems ETFs pose is… most people have absolutely no idea what the heck they’re buying into when they buy ETF shares.

Somehow (I wonder how), in the minds of the investing public, ETFs are some sort of magical black box that’s completely disconnected from the ownership of individual common stocks.

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For instance, a friend of mine runs a successful value-oriented hedge fund.

He told me that he recently turned down a wealthy woman who wanted to invest $1 million in his fund.

When he spoke with her, she intimated that she had no money in the stock market, but thought she should have some exposure, so mutual friends suggested she contact him.

He asked her what she had been doing with her assets.

Now, he expected to hear “real estate,” or “a family business,” or “municipal bonds,” or some other asset class that is frequently owned by high-net-worth investors.

Turns out, she owned a bunch of ETFs. But she didn’t consider them “stocks.”

He passed on accepting the investment, suspecting – correctly – that a mindset in which ETFs and the stock market were disconnected would make for a “difficult client” in the years ahead.

Sometimes, a million bucks just isn’t worth the headache.

Now, I’d like to think that this appalling, fundamental misreading of reality is just one slightly befuddled individual’s mistake…

…but this is not the case – especially when it comes to index ETFs.

According to a study done by Fidelity Investments, around 20% of fund investors thought that owning index ETFs would protect them from the ups and downs of the stock market.

Before we hasten to conclude that one in every five Fidelity customers is just not very bright, consider that Natixis Global Asset Management conducted another study. It found that 60% of investors think using index funds can help minimize investment losses.

They say you shouldn’t attribute to malice what can be adequately explained by stupidity, but in this case, I think Wall Street has utterly, deliberately bamboozled hundreds of thousands of regular investors here.

And so people are throwing enormous sums into ETFs and have no idea what they own.

Hindenburg

Consider that U.S. ETFs currently have more than $3 trillion in assets under management.

More than half of that money has come into the funds in the last five years, after the bull market began.

These investors have never really seen a down cycle in the markets. Hell, they’ve rarely ever seen a down month on their statements.

When we do finally see a bad market (and we will eventually see a bad market), then the reality of the fact that they own stocks – stocks that are going down like the Hindenburg – will hit them like a ton of bricks, and they will begin to sell.

It will be ugly.

And it will get uglier.

Hindenburg

That’s because nearly all of the thousands of ETFs constituted out there are based on an index. Even the sector funds are based on an underlying index.

As money comes in and out of the fund, they have to buy and sell the underlying stocks in the same proportion as their index representations.

An active manager can hedge his or her positions and pick and choose which stocks to sell, and, if necessary – and if they’ve got a brain in their skulls – get the hell away from (or, even better, short) stocks that are plummeting like burning zeppelins.

But the folks running the show at the ETFs? Not so much. They don’t really have a choice. They must sell in proportion to the index percentages regardless of quality or liquidity concerns.

They can clearly see the blimp crashing and burning… and they have to buy themselves – and the millions of investors who own their products – a ticket to ride.

Hindenburg

And ride the Hindenburg they will, all the way down.

Oh! The humanity…

Like I said: ugly.

As ETFs become more popular, we are taking a natural buyer out of the market. ETF managers do not buy or sell because they are bullish or bearish: They buy and sell because of public order flow.

So if everyone owns index ETFs, and everyone is trying like mad to sell…

…then who’s buying?

Get Ready for the “Day of the Vultures”

ETFs

Well, the answer is: a bunch of scavengers – rich scavengers – that look a lot like me, and guys like Seth Klarman of Baupost Group, Michael Price, the legendary Mutual Series funds manager, Paul Isaac of Arbiter Partners, and Warren Buffett and Charlie Munger at Berkshire Hathaway Inc. (NYSE: BRK.ABRK.B).

Also lining up to buy the ruins will be private Equity firms like KKR & Co. LP (NYSE: KREF), Apollo Global Management (NYSE: APO), Blackstone Group LP (NYSE: BX), and other long-term-oriented, “price-sensitive” investors.

This will compound the problem for ETF investors.

The vultures will know ETF owners are scared, well aware folks are selling ETF shares and forcing the managers to engage in pile-on selling.

So the price the vultures are willing to pay will be much, much lower than the current quote.

It will be like playing poker with someone who can see your cards. The vultures – the smart, smart, vultures – will collect an enormous amount of money by acting as the buyer of last resort.

ETFs are convenient. They are liquid. They allow you to own the whole market or designated parts of the market at the punch of a button.

And, as I’ve shown here, they are also fatally dangerous in a sell-off.

The fact that you can sell intraday means ETF shareholders can let imagination and panic run wild all day and sell, sell, sell.

In previous meltdowns, fund redemptions could not be processed any sooner than the close of the day; a person had some time to think and perhaps allow a shred of rational thought creep into the decision process.

Next time it will be pure, raw, terrible emotion thanks to instant liquidity. The sell-off will be far worse than it should have been thanks to ETFs and their dastardly, fatal liquidity.

So what is an investor to do? How do we earn unreasonably good returns in the face of the popularity and potential dangers of ETF?

The simple answer is that we avoid owning what they own. Most ETFs are invested in large-cap stocks, and there is not really any valid reason for us to own these.

They are not even reasonably priced, much less undervalued, at current levels. The recent sell-off did… absolutely nothing to rein in valuations.

We look for good companies at unreasonably great prices that are not heavily owned by the ETFs and will not be subject to forced selling a bad market.

We search for opportunities to directly own assets that produce high levels of cash flows and buy them at a discount to their actual value.

We look for situations where we can put money to work in high-return situations where collateral value has more to do with the end result than market movement.

Sir John Templeton once said that you cannot outperform by doing what everyone else is doing.

Right now, everybody else is buying ETFs, and when the market turns, it will end badly – “Hindenburg badly” – for them.

We need to be different in our search for unreasonable profits.

 

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