Warren Buffet once humorously said that "it's only when the tide goes out that you learn who's been swimming naked." In the current financial crisis and now that the tide has clearly gone out, who has been bathing in the nude? As such, how have ETFs been exposed through the current crisis? And, could the ebb and flow of previous financial tides help investors today?
The recent wave of complex financial products has truly been epic. Many of these products will be thrown into the dustbin of financial history. Fortunately, exchange-traded funds will not fall into that category. After all, ETFs are simply tax-efficient tracking vehicles with full transparency and low costs (collateralized by the underlying securities).
While large mutual fund redemptions have been common in recent months, the ETF market has remained a beneficiary of net inflows. According to the Investment Company Institute, US mutual funds (excluding money market funds) had net outflows of USD 31 billion for the year through September. During the same period, figures released from the National Stock Exchange showed net inflows of USD 103 billion into exchange-traded products (which includes ETFs and ETNs). A similar trend is evident in Canada. Figures released from Barclays Canada show Canadian iShares ETFs with net inflows of CAD 2.1 billion in September and October, while mutual funds saw outflows of CAD 12.95 billion during those months.
Current market conditions have witnessed cases of liquidity loss or trading aberrations. For example, the SEC's ban on short-selling financial stocks has created some uncertainty in Rydex and Proshares short-financial ETFs. By and large, however, ETFs are proving to be powerful portfolio building blocks through this tumultuous time in financial history ... definitely donning a pair of swimming trunks.
That being said, ETFs are merely investment instruments tracking various types of indices. They do not guarantee superior portfolio performance, nor do they prevent investors from making some of the same errors that continue to be repeated. Let's turn our attention to observations from financial history and determine some ways that we can learn from it.
From Risk to Recoil ... And Repeat. Perhaps the most intriguing phenomenon in financial markets is the tendency of participants to have to relearn the same lessons time and again. Financial markets have a consistently cyclical nature to them, oscillating between exuberant greed and catatonic fear. Yet, as we see today, every new financial crisis is declared as "unprecedented" and much different from anything in the past. Today's crisis has not escaped such labeling. In a recent issue of the New York Times, Senator Charles Schumer described the current credit crisis as a "new world "and "uncharted territory." But is this really the case?
It's true that each financial crisis has certain aspects that are unique. But recent events in financial markets are following the classic boom-bust script -- from credit over-expansion to the inevitable painful aftermath. This is certainly nothing new in financial history. Sadly, recurring human investment errors are also part of the historical financial landscape.
Is the Past Relevant? Before we proceed, an obvious question to ask is can investors learn from financial history at all? After all, the same errors are repeatedly made. But financial markets and investor behaviour consistently display similar patterns. It is these recurring patterns that should be examined for insight and possible guidance in a contemporary context. Therefore, an awareness of financial history and its cyclicality is crucial to managing portfolios using ETFs.
Admittedly, the study of financial history is not a hard science and will not produce elegant mathematical equations. But it can have important practical implications for the management of portfolios.
Learning From a History of Booms and Busts. Let's look at some common features evident in the historical investment landscape and place them in today's context:
• Investment Flows Chase Performance. It's a long running adage that investments are sold and not bought. And they sell best at price peaks. Unfortunately, investors tend to invest most aggressively after large price run-ups. Predictably, outflows tend to peak near market troughs (as may very well be the case in today's markets).
Consider foreign-currency ETFs for US domiciled investors. After a multi-year decline in the US dollar, currency ETFs soared in popularity among the US retail crowd. In fact, despite being latecomers to the ETF space, there were almost 30 US-listed currency ETFs with over USD 5 billion under management (as of July 2008). Measured by asset size, the CurrencyShares Euro Trust was the most popular currency ETF - it had accumulated close to USD 1.5 billion as the Euro was peaking at 1.60 USD/EUR.
Even more alarming was the growth in commodity ETFs as prices hit multi-year highs. In an industry known for its cyclicality, this publication advised investors to exercise caution. Compared with traditional asset classes, corrections can be more abrupt and additional factors such as weather, growing patterns and seasonal tendencies are present. However, for the year through June 2008, inflows into commodity ETFs reached USD 6.4 billion on an overall asset base of over USD 40 billion. As commodity prices have fallen sharply, large net redemptions from both currency and commodity ETPs have been seen - over USD 2.5 billion for the month of October alone.
• Behavioural Biases Often Drive Investment Decisions. The emerging field of behavioural finance is replete with examples of emotional biases that impede successful portfolio management. A study in the March/April 2008 issue of the Financial Analysts Journal entitled "Affect in a Behavioural Asset-Pricing Model" identified an emotional risk (called "subjective risk") not addressed in modern financial theory.
The researchers studied stock surveys from Fortune Magazine from 1983-2006 and found that returns from admired stocks were lower than the returns of spurned stocks. The reason? Investors prefer stocks with a positive 'affect', thus driving up the stock price and decreasing their longer term returns. The reverse holds true in shunned stocks. The same phenomenon holds true for any hyped investment story or darling stock sector (including ETFs).
• Risk is Underestimated During Financial Booms. All booms are marked by rapid credit growth and financial liberalization. Importantly, lenders and investors vastly underestimate risk. But as former Federeal Reserve Chairman Alan Greenspan noted in 2005, "history has not dealt kindly with the aftermath of protracted periods of low risk premiums."
Sure enough, after an extended period of stability, we are at that point in history again. Investors came to view the environment of the last few years as structural and permanent. Home prices were thought to rise forever. China would continue to grow at over 10% annually. And interest rates would stay low for the foreseeable future.
Consider the increase in risk in the typical investor portfolio. Many Canadians had heavily-concentrated resource portfolios with little diversification. And, many model portfolios labeled as "conservative" or "balanced" had exposure to asset classes that were outside the risk parameters of those mandates.
Or consider the case of ETNs. Compared to traditional ETFs, they were marketed as debt securities with no tracking error. Essentially, the issuer guarantees the return of certain published indices through an issued note. But an important and often overlooked risk was added - credit risk of the issuer. Unfortunately, the now-bankrupt Lehman Brothers Holdings was one of the issuers of ETNs with their three Opta ETNs. Shareholders must now line up in the bankruptcy queue. While the risk of issuer default may have been remote, it highlights that risk should be a central focus of investment programs in all types of markets.
• Markets Overshoot and Create Opportunities. Now, for the good news. As we've seen, the human elements of greed and fear ensure that financial markets remain cyclical. Asset values overshoot on the upside and undershoot on the downside. Forced liquidations and panicked selling can create incredible opportunities as investments are indiscriminately sold. Now may be one of those times. Ned Davis research reports that its "crowd sentiment poll" has logged a more extreme pessimistic reading than at the 2002 market low. A number of other indicators point to investor panic not seen in decades.
After a lengthy period of overvaluation in many asset classes, value is returning to some investment classes. Many ETFs are down over 50% this year. While most investors remain paralyzed with fear and anxiety, prudent investors are silently repositioning their portfolios and taking advantage of some historically low asset prices.
Looking Ahead. History shows us that financial busts achieve a necessary purging of risks, malinvestment and mispricing. Competition again increases, fees are lowered and the product shelf becomes less cluttered. There are signs that this has begun. For example, PowerShares FTSE/RAFI ETF portfolios have lowered their fees (now 39 basis points) and 40 unsuccessful ETFs have closed this year in the US.
However, we should not lose sight of the benefits of ETFs and their durability through market volatility. They eliminate corporate or issuer specific risk, and help investors focus on asset allocation rather than chasing fad investments. Building sophisticated globally-diversified low cost portfolios is now possible exclusively with ETFs - unquestionably, that's a positive step forward in financial history.
