Tuesday, June 27, 2017

Are ETFs Driving The Market Higher?

Evelyn Cheng of CNBC reports, Goldman says there's one major force behind the market's gains this year: ETFs:
Passive investing is taking a bigger share of the stock market, helping to drive gains.

Exchange-traded funds, or ETFs, owned nearly 6 percent of the U.S. stock market as of the end of the first quarter, their greatest share on record, according to analysis by Goldman Sachs.

Known as passive investments, ETFs are baskets of stocks tracking various market indexes and have grown in popularity for their relatively low fees. In contrast, mutual funds that involve higher-cost active stock picking have declined in popularity, and their ownership of the U.S. stock market has fallen to 24 percent, the lowest since 2004.

ETFs purchased $98 billion worth of stocks in the first quarter, putting them on pace to buy $390 billion of stock this year, more than the last two years' combined total of $362 billion, according to the Friday note by a group of analysts led by Goldman's chief U.S. equity strategist, David Kostin. Goldman based its analysis on the Federal Reserve Board's June 8 report on first-quarter U.S. financial accounts.

ETF ownership of equities is at the highest level on record, as of the first quarter (click on image):

Source: Federal Reserve Board and Goldman Sachs Global Investment Research.

Analysts said the growth of ETFs can help explain why stocks have gained this year despite delays in passing the Trump administration's pro-growth proposals and increased geopolitical worries.

"I agree that ETFs have been a big driver," Ilya Feygin, managing director and senior strategist at WallachBeth Capital, told CNBC in an email. "The market has often made strong gains in weeks of strong inflows even in the face of bearish macro news. It has paused when there is not much inflow or the inflow went to international ETFs instead of U.S."

In a sixth straight quarter of gains, the S&P 500 climbed 5.5 percent in the first quarter to record highs. The index is tracking for gains of more than 3.5 percent this quarter.

Corporate buybacks and foreign investors also have driven demand for U.S. stocks.

Share buybacks were still the largest source of demand for stocks in the first quarter at $136 billion, or 46.6 percent of purchases, the Goldman report said, while the first quarter marked the second time in the last eight quarters that foreigners bought more U.S. stocks than they sold.

Momentum behind U.S. stocks could fade

That said, Kostin doesn't expect the strong demand for U.S. stocks in the first quarter to hold.

Goldman's year-end target for the S&P 500 is 2,300, about 5.7 percent below Friday's close of 2,438. U.S. stocks were slightly higher Monday, with the S&P near its record high hit June 19.

Expectations for a slight decline in U.S. stocks should lead to "a modest deceleration in ETF purchases" in the second half of the year, the report said, while a switch to passive management will add to mutual fund withdrawals.

Since 2007, $3.1 trillion has flowed into passive bond and stock funds, while $1.3 trillion has flowed out of actively managed bond and stock funds, according to a Bank of America Merrill Lynch report Thursday.

Cumulative active vs. passive flows to bond & equity funds ($ trillions)

Source: BofA Merrill Lynch Global Investment Strategy, EPFR Global

Stock buybacks are also on the decline and should weigh on market returns. Kostin cut his forecast for corporate buyback growth this year to 2 percent from 11 percent.

"Our new estimate excludes any boost from tax reform in 2017 and also accounts for weaker activity in 1Q," Kostin said in the report. He previously expected tax reform this year to result in firms bringing back cash from overseas and using those funds to buy back shares.

Over the 12 months ended in March 2017, buybacks for S&P 500 companies declined 13.8 percent from a record high in the same period a year ago, according to Howard Silverblatt, senior index analyst at S&P Dow Jones Indices.

Second-half fund flows should support overseas markets

On the other hand, improved growth in Europe and the rest of the world should benefit stocks outside the U.S.

Goldman expects the Europe STOXX 600 to gain 6 percent over the next six months in local currency terms, Japan's Topix to climb 2 percent and the MSCI Asia-Pacific ex-Japan Index to rise 1 percent.

"Higher return potential in major non-US equity markets vs. the US and a political stalemate in Washington D.C. suggest foreign investors will be net sellers of US stocks in 2H," Kostin said in the report.

Kostin also expects better returns overseas to attract U.S. buyers, who already bought $83 billion in foreign equities in the first quarter, reversing a trend in five of the last six quarters of selling more foreign stocks than buying.
When Goldman talks, investors listen. Alright, let me begin by stating there is a giant passive 'beta' bubble going on driven by the increasing popularity of exchange-traded funds (ETFs) and digital (aka robo) advisors. I've written all about it in my comment on the $3 (now $4) trillion dollar shift in investing,

Jack Bogle has revolutionalized the investment world for the better but in the process of doing so he may have created a monster that will sow the seeds of the next major financial crisis. This may be the Mother of all beta bubbles but it's very hard for people to realize it until the crisis hits and the dust settles.

And if history is any guide, these bubbles last a lot longer than investors can fathom. Martin Lalonde, manager of Rivemont, sent me a nice comment by the Collaborative Fund, The Reasonable Formation of Unreasonable Things, which you can read here (this is an excellent read).

Nevertheless, one thing is for sure, even if the stock market is on a tear, the US economy is slowing as I discussed here and here. At one point, the liquidity party will dry up, credit spreads will widen, and companies won't be able to borrow as much to buy back shares which will pretty much spell the end of the bull market (share buybacks have been the biggest factor driving shares higher).

Having said this, it's very hard calling a top when there is still plenty of liquidity driving risk assets higher. Sure, stocks are not cheap based on the CAPE ratio or "Shiller PE" but as Charlie Bilello of Pension Partners notes in his comment, Is This 1929 or 1997?, relying on this indicator to predict future returns isn't particularly wise.

As I end this brief comment, markets are selling off. I was busy earlier today attending a CFA luncheon where I enjoyed listening to macro views from some astute market observers. I will share some thoughts from this luncheon in a follow-up comment.

As far as what's driving the market higher, I would say central banks, share buybacks, ETFs and animal spirits. Is passive investing going to continue growing? Of course, but this growth will present opportunities to active managers especially when markets tank again.

One final note on ETFs and the VIX (or fear) index. As mentioned in this article, the rise of ETFs is impacting the volatility index through hedging activities:
Deshpande and other derivatives market experts say speculators are to a large extent just selling VIX futures to the issuers of exchange-traded products (ETPs) who need protection against volatility.

With the S&P 500 stock index .SPX near a record high, demand for these is quite strong.

For instance, money flows into the iPath S&P 500 VIX Short-Term Futures ETN (VXX.P), the most heavily traded long volatility ETP, are the strongest in three years, according to data from Lipper. In turn, that's creating steady demand for VIX futures that the hedge funds are only too happy to supply.

"Strong inflows into long VIX ETPs means the issuers of these products have to go and buy VIX futures," Rocky Fishman, equity derivatives strategist at Deutsche Bank.

Even in the absence of those inflows, the way these ETP products work means that as market volatility declines it requires these product issuers to buy more VIX futures contracts.

It is in response to this strong demand for VIX futures that speculators have ramped up the selling of VIX futures. Essentially, these funds are acting as liquidity providers, not making outright bets.
Below, Bloomberg Intelligence's Eric Balchunas and Bloomberg's Julie Hyman look at claims that ETFs are inflating stock prices and creating a market bubble. They speak on "Bloomberg Markets" (March 24, 2017). Good discussion, listen carefully to his comments but keep in mind the trend that Goldman notes above.

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