Whether it is the tulip mania of 17th century Holland or US technology stocks during the late 1990s, financial bubbles have been recurring features of the historical investment landscape. With the rapid proliferation of exchangetraded products in the last decade (from only 21 ETFs worldwide in 1997 to 1,171 ETFs globally as of year-end 2007), some have concluded that the ETF marketplace itself is heading towards its own bubble. But really?
It's true that the worldwide ETF space is booming. Listings and trading volumes have soared in recent years. Deutsche Börse's pan-European Xetra trading platform now lists 326 ETFS with an average monthly trading volume of over EUR 9 billion. In Canada, Horizons Betapro has already accumulated assets of over CAD 1.75 billion, despite being a relatively new ETF provider.
It's also a correct observation that many of today's ETF offerings are only distant relatives of the earliest vehicles. Compared to the earliest vintage which tracked only the broadest indexes, funds of all types have been launched or proposed -- from orthopedic repair funds to ETFs focused on companies in the state of California. While ETFocus has repeatedly highlighted the benefits of exchange-traded products, we have also warned against the potential pitfalls associated with some of these developments. And, we have agreed with many critics when cautioning ETF investors (see ETFocus response to John Bogle, "Invasion of the Mutant Indexers?", June/July 2007).
But criticisms against ETFs have centered around longer running problems within investing in general - performance chasing, excessive trading, ignoring risk, inadequate diversification and inappropriate asset allocations. These hazards could equally apply to mutual funds or any other type of investment ... indeed, even tulip bulbs. Critics are missing the real essence and are simply looking for scapegoats to common pitfalls that have always plagued investors. ETFs themselves can hardly be blamed.
So, can the "bubble" label really apply to ETFs? Are they not just tools to implement varying investment strategies? Do they really add or cause inflation to an underlying asset class? Not at all.
There are all types of ETFs covering asset classes from biotechnology to agricultural commodities. If investors can establish exposure more effectively (one-stop diversification, tax efficiency and lower expense ratios), then are they not better off? Let's turn our attention to the makings of a true financial bubble to further establish the point.
Understanding Financial Bubbles. Throughout financial history, asset bubbles of all types -- although each unique in their own way -- have shown similar patterns. If these speculative manias can be identified, what lessons can be learned? And, importantly, what are the implications for managing investor portfolios? With the backdrop of deflating bubbles worldwide (particularly in global real estate), it is a timely question.
Let's first examine the ingredients and conditions that are necessary for the development of a bubble. Much has been written on the subject. Notably, Austrian School economists, such as the late Ludwig von Mises, have made significant contributions to the understanding of financial bubbles. And, they have analyzed secondary effects such as changes in consumption and "malinvestment" (capital structures which are created during the bubble period, but unsupported by real demand).
Broadly speaking, however, three main factors work together to produce asset bubbles: positive economic fundamentals (initially, at least), investor misconception and financial leverage. The first and second factor work together to produce a widespread belief in a "new paradigm". The third factor is the fuel that drives prices upward ... provided of course that there is ample expansion of money and credit.
Bubble Blindness. Let's start with the first two factors. Clearly, the impetus for a financial bubble must initially have some fundamental economic merit. As investors experience gains in the related asset, fundamentals are conveniently ignored and a broad-based investor misconception eventually takes hold. A "story" typically develops that is circulated and reinforced in the populace. Eventually, the concept is taken as an inalienable truth and extrapolated ad infinitum.
As the bubble-phase is entered, traditional constraints of supply and demand are dismissed. This is the greed phase where investors believe that it is truly different this time. In a capitalist economy, an increase in the price of an asset should produce a normal competitive supply response. But during bubble periods, investors do not anticipate any response at all. In fact, the data is ignored altogether, even while the fundamental trends have reversed course.
Fueling the Mania. Lastly, and perhaps most importantly, bubbles include rapid credit expansion with the targeted asset serving as collateral. In all cases, a positive feedback mechanism develops that causes asset prices to deviate sharply above intrinsic values. (This is an aspect of George Soros's concept of "reflexivity", where a circular connection is established between the willingness to lend and the value of the collateral). Creditors are emboldened to take on more risk by the further rise in asset prices, while debtors are willing to borrow more and bid up the price of the asset. The eagerness of lenders to lend and the price of their collateral rise and fall together.
Whether the financing is provided from traditional channels such as commercial banks, or funding is accessed through capital markets (equities, bonds, etc.), all financial market manias have had a central feature of financial liberalization. This includes declining loan quality, an influx of new credit providers and a broad acceptance of lending against assets (rather than underlying income). Of course, this leads to an undercharging for credit and a broad underestimation of risk.
During the South Sea bubble -- England's first great stock market crash -- individual investors financed stock purchases on bank credit and margin, evidenced by record bankruptcy listings in the London Gazette following the market decline. Most recently, the global real estate bubble expanded along with the largest credit boom in financial history.
The Inevitable Crisis. How are asset bubbles usually pricked? Whether it is a financial disaster (e.g. hedge fund blowup) or simply an inevitable inability to service the debt load, the decline may be initiated by any number of different catalysts. But pricking a bubble can be compared to playing with matches in a room drenched in gasoline. The environment is flammable and sooner or later a fire will erupt.
During the inevitable bust phase, a negative feedback mechanism develops which prolongs the decline and subsequently causes prices to fall below fair value. The extent of the decline in asset prices varies. Austrian School economists theorized that the magnitude of the bust is proportional to excesses created in the prior boom. Yet, the important point to make is that financial markets gyrate, overshooting during the boom and undershooting during the bust.
As asset prices serving as collateral on loans collapse, the bubble falls apart. Creditors are alarmed, calling in their loans and raising the cost of capital. Default rates spike and bankruptcies erupt. Investor misconceptions which promoted the bubble are quickly replaced with fear and the obviousness of prior investor foolishness. With investor revulsion, the lifecycle of a bubble is complete. At this point, opportunities abound for brave-hearted investors ... a time we again anticipate sometime soon in the current environment.
Responding to a World of Chronic Bubbles. Placing ETFs in the bubble category fails to understand the true nature of asset bubbles. ETFs are not a credit-generating vehicle. Consider today's ETF climate. In the context of declining global equity markets, ETF product launches have slowed (with some closures also being announced). Does this then mean that an ETF bubble is deflating? Of course not. In fact, product closures and MER competition among ETF providers is healthy competition and is a positive for the industry. Make no mistake, ETF usage and listings will continue to expand for the simple reason that they are a better mousetrap than many traditional investment vehicles.
But given that ETF investors still face a world of persistent bubbles, how should they react? We could expand on this topic at length and will return to this theme in future issues of ETFocus. From a policymaking standpoint, we disagree with central bankers who maintain that asset bubbles should not be proactively targeted. For example, the US Federal Reserve could have thrown cold water on the dot com frenzy by raising margin requirements. More recently, policymakers around the world could have imposed restrictions on innovations in exotic security-types and home down payment requirements to reign in overzealous mortgage lenders.
Alas, investors today do live in a world of chronic bubbles. And, this is where we depart company with proponents of the efficient markets hypothesis (the theory that markets are perfectly rational and accurately priced). Markets are not always rational being prone to bubbles. Therefore, investors cannot take an exclusively passive approach. This does not mean shouting "bubble!" and selling an asset every time it rises in value. Rather, a disciplined value and risk-sensitive approach should be employed which emphasizes material strategic shifts and eliminates emotional biases. ETFs promote a focus on broad asset allocation, rather than reacting to the barrage of news that inundates investors daily.
