This Might Be The Biggest Risk To The Stock Market

March 13, 2018

This Might Be The Biggest Risk To The Stock Market

  • ETFs have grown extremely fast in the last 10 years.
  • This amplifies the risks of the stock market because, since when does the majority know what’s best?
  • There is one small example of what happens when things stop growing.


I’ll close my series on the risks to the stock market by discussing a risk that few see where the prevailing wisdom in one of investing through passively managed mutual funds and ETFs. This is creating a big risk, even if it doesn’t look like that now. Let me elaborate on that.

Flows Of Funds

If there is more money flowing into the market than going out, markets go up. This is something simple to understand and a look at the past inflows shows how January 2018 was a record month for the flow toward passively managed investing vehicles.

Figure 1: In January 2018, inflows were 30% higher than they’ve ever been. Source: Bloomberg.

Take a look again at the figure above. The sharper the S&P 500 rises, the higher the inflows have been.

Figure 2: S&P 500 in the last 3 years. Source: CNN Money.

In 2015 and 2016, when the S&P 500 was flat, inflows were just one third of the inflows in 2017. Now, what will happen when the bullishness driving the market up turns into bearishness and we see more outflows than inflows? As most investors, especially those who invest now in the late part of the economic and market cycle, invest in fear of missing out and because of a “look at how good stocks have performed in the past” attitude, we can only imagine what will happen to stocks when this trend reverts. A few points:

Firstly, as so much money goes into passively managed funds, it also shows the lack of sophistication of the same money. Sophisticated investors buy positions directly, you have never and will never see Warren Buffett own the S&P 500. Secondly, investors who buy into passively managed funds, thus into a little bit of everything, aren’t buying parts of businesses, they are buying stocks. Similarly, they will be selling stocks when stocks turn downward. This amplifies the risk of cascading and might increase market downturns.

Fundamentals Have Been Forgotten

Passive investing looks only at one thing, market capitalization. The higher the market capitalization, the higher the weight in a passively managed index or ETF.

Now, if most invest passively, active managers who follow fundamentals can’t have an influence on the price and therefore there is no adjustment to fundamentals. When fundamentals don’t matter, things get extremely risky.

ETFs Are Getting Too Big

The bigger an ETF is, the greater the liquidity of the underlying assets should be because an ETF has to buy or sell assets in relation to the flows coming in or going out. We haven’t yet seen what a year looks like where there are mostly outflows from ETFs.

Figure 3: ETF creation and redemption process. Source: Vanguard.

So if an ETF has lots of redemption requests, it has to dump the assets on the market. The bigger ETFs get, the bigger the risk is for the underlying market. Further, in the past we’ve seen only ETF growth and not even one negative year. I believe the first negative year will create unexpected consequences.

Figure 4: ETF growth over the past 10 years. Source: Bloomberg.

From the above, you can see that ETFs that represent commodities have seen outflows since 2012. The situation for commodities is still terrible when compared to the 2012 peak.

Figure 5: Bloomberg Commodity Index. Source: Bloomberg.

I wonder whether we will see the same result when the current extreme growth ETF trend reverses. Not that ETFs pushed commodities down, but the result might be the same.

Conclusion & What To Do

Now, I’ve described the risks related to the stock market from the debt, valuations, book values, and now ETFs and passively managed funds. When you combine all of those insights, you might think the market will crash tomorrow. The fact is that as long as those trends continue to move as they have been moving for the past 9 years, the party will simply continue to go on. This doesn’t mean that there is no risk, we saw how fast stocks dropped last month while now it again looks like nothing happened.

I know one thing, everything works in cycles and so do markets. The answer to what you have to do can be found only in your personal situation. Remember that Warren Buffett has 40% of BRK’s stock portfolio in cash, Seth Klarman is also close to that level. So the thing to think about now is how much cash you hold even if stocks go up another 50% in the next two years. Successful investing over the long term is about the risk reward, not about making a few good bets here and there because that usually ends up badly.

So the options are to hedge yourself, do nothing, have more cash, or steer toward an all-weather portfolio. Your choice.