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The stock market is not a movie theater!


Richard Morin

Update :
Update :
September 26, 2019

La Presse recently published an article entitled "Les fonds indiciels vont-ils faire capoter les marchés? The title is catchy but unfortunately, the experts consulted by La Presse present theories that do not really correspond to reality. I would like to set the record straight.

Basically, the experts quoted in the article (Mo Chaudhury of McGill University and Shady Aboul-Enein of HEC Montreal) make 2 points. First, because they indiscriminately buy all the stocks in an index, index ETFs " up those stocks, regardless of their fundamentals..." and risk "aggravating a (potential) bubble...".

Second, it is argued that ETFs' use of derivatives "typically purchased with high leverage" could lead to a 2008-like scenario "that pushed large financial institutions over the edge."

Mr. Aboul-Enein even uses an analogy between the FNB and a crowded movie theater: "If there is no fire and people leave calmly, there is no problem. But that doesn't seem realistic to me. Phew! Should we call the fire department?

A little historical reminder

Before addressing the issues raised in the article, I think it would be relevant to recall the context in which ETFs were born.

After the 1987 crash - a 22% drop in the S&P500 in a single day - the U.S. Securities and Exchange Commission published a report in which it identified the causes and proposed solutions. According to this report, the crash was caused essentially by "program trading": computers were programmed to automatically sell all the stocks in the S&P500 if the index fell below a certain level. This was called "portfolio insurance"!

The SEC report postulates that if market participants had had access to a "product" that allowed them to trade "baskets" of all the S&P500 stocks among themselves without selling each of the stocks on the exchange, the crash could possibly have been avoided. The idea of the Exchange Traded Fund was born!

As a direct result of this report, the American Stock Exchange launched the first ETF in the United States (SPY, which mimics the S&P500) in 1993, but not before the Toronto Stock Exchange "stole" the idea and launched the world's first ETF (Toronto Index Participation Securities, the forerunner of XIU) in 1990.

The reason I'm telling you all this is to explain that the original ETF was designed to address a liquidity and market efficiency problem. It has been a success all around. Today, you can own the 500 stocks of the S&P500 for as little as 0.03% annual fee. Of course, this does not please the traditional portfolio managers who charge more than 2% per year for the same service. They are the ones who are now blaming ETFs for everything!

Yet ETFs are nothing more than mutual funds 2.0 that, like their cousins, contribute greatly to the democratization of investing and market efficiency.

Mutual funds and ETFs: close cousins

Mutual funds and ETFs are very close cousins. They are set up the same way:

  • A trust pools the assets of a number of investors
  • A fund manager manages these assets according to an investment policy
  • A valued custodian ensures the security of the fund's assets
  • An administrator keeps the fund's accounts and calculates the net asset value each day

The only difference is that investors buy and sell ETF units on the exchange - hence the name - unlike a traditional mutual fund that redeems its own units at the investor's request. It is this innovation that is the main contribution of ETFs to market efficiency: when you sell your ETF units to another investor on the exchange, the ETF manager does not have to sell the securities held by the fund. So the goal of the SEC report has been achieved, and that's good. As an added bonus, unlike traditional mutual funds, the sale of your ETF units has no tax implications for other fund holders.

Otherwise, mutual funds and ETFs use the same investment strategies and invest in the same securities: publicly traded stocks, bonds and derivatives.

Again, derivatives!

In the La Presse article, Mr. Chaudhury sounds the alarm about the use of derivatives by ETFs. To hear him tell it, one would think that the use of leveraged derivatives is common in ETF management. Nothing could be further from the truth!

The assets of ETFs listed on US exchanges total $4 trillion [1]. The largest of these is SPY (SPDR S&P 500 ETF Trust), which has assets of $268 billion and physically holds the stocks that make up the S&P500 index, of course without leverage. By comparison, the largest ETF using leveraged derivatives (TQQQ, ProShares UltraPro QQQ) has total assets of $3.7 billion, a drop in the bucket.

Leveraged ETFs are like casinos: it is only a matter of time before their followers lose their capital, with or without the help of a crash. It will be unfortunate for them, but without serious consequences for the financial system.

It is important to note that the rules governing the use of derivatives by ETFs are the same as for mutual funds. It is therefore difficult to understand why Mr. Chaudhury is concerned about the former but not the latter.

The stock market is not a movie theater!

Canadian investors collectively hold $4.4 trillion in financial assets, invested in GICs, stocks, bonds, mutual funds and ETFs. Of this total, at the end of 2018, mutual fund assets amounted to $1.58 trillion compared to $157 billion for ETFs. Now, as I mentioned above, mutual funds are structurally identical to ETFs and leverage the same investment strategies (it's an open secret that the largest mutual funds in the market essentially invest in the stocks that make up the market index, as do index ETFs). Yet our 2 experts don't seem to be concerned about the risks posed by mutual funds.

What does this have to do with film? I'll tell you. The "movie theater" that Canadian investors are attending is called retirement: their $4 trillion in assets are invested for their golden years. They're not going to suddenly liquidate everything - get out of the movies - because the stock market is in a tailspin! Nor are their $157 billion in ETFs or their $1.58 trillion in mutual funds.

Let's be clear: bear markets and excessive volatility will continue to shake the financial markets. They are as inevitable as they are unpredictable, and ETFs have nothing to do with it. On the contrary, when misguided (or misguided!) investors sell their securities in a panic, convinced that the end of the world is near, smart investors can buy ETFs at a discount. That's what real investment experts do!

1] Million of millions