The Rotation Game and the Rise of ETFs

Anybody who has spent a meaningful amount of time watching and studying the market knows that there is a regular/ongoing “sector rotation” that occurs. Groups of stocks in related industries will move, often in apparent lockstep, during trading sessions. Sometimes these rotations occur with subtlety over longer periods of time. But in today’s fast-moving markets these shifts are often rapid and can occur in a knee-jerk in fashion.


In my humble opinion, these market moves have become much more pronounced in recent years, in large part due to the proliferation of exchange-traded funds (ETFs). I am not necessarily referring to passive index funds that are designed to mirror broad-based domestic and international markets. Rather I am referring to ever more specialized ETFs that are designed to give exposure to specific industries like retailing, banking or utilities, ETFs designed to capture a theme like social media or cloud computing, and more esoteric ETFs that use names like “Smart Beta” whatever that means. Even riskier are ETFs that use leverage to amplify returns (and losses), as well as their alter egos that provide inverse market returns by using options and short-sales. A quick Google search indicates that there were nearly 7,000 actively traded ETFs in 2019 (as well as 110 ETFs that closed in the same year). To complicate matters further, many seemingly unrelated ETFs might hold positions in the same security, creating a tug-o-war of sorts. In my opinion, a noteworthy side-effect of all these competing financial products is that they actually make the market more opaque, making it more difficult to discern if a particular security is rising or falling for a fundamental, company specific reason, or if it is simply caught up in an ocean of competing financial innovations.


Recognizing that my opinion may be unpopular, I don’t mean to denigrate all ETFs, rather I am more interested in explaining how their growing popularity influences the behavior of markets. I understand why some investors use them and acknowledge that different investment vehicles have their respective pros and cons. For example, ETFs generally have lower fees than their mutual fund cousins. ETFs can also be actively traded throughout the day while mutual funds only allow entry and exit at their closing net asset value (NAV). For a portfolio with limited investable assets, ETFs and index funds provide exposure to several underlying securities without needing to buy shares of many different stocks (which may mean more transaction costs). Financial planners (which the writer of this blog also happens to be), often use ETFs for their efficiency and the time it saves performing due diligence on individual companies and stocks (something the writer of this blog spends much of his time doing). Still, it is worth questioning how many ETF flavors is too many and if they are all truly serving their stated purpose or if they are simply generating fees for their sponsors who constantly create new ones. Too much of a good thing is…usually not a good thing.


So why bring this up now? I started this post by talking about market rotations. Sometimes these rotations are more subtle, but sometimes they are so stark that I have to scratch my head and wonder if the tail is wagging the dog. Too often I believe securities exhibit undue price volatility simply by virtue of their inclusion in a particular index or ETF. On Monday of this week, news broke that a COVID-19 vaccine in development by Pfizer and BioNtech was over 90% effective. This surprise news sent the market into a rotational tailspin. At the flip of a switch almost every stock that had performed well in the “stay-at-home economy” got dumped while the stocks associated with an actual economic recovery took off. This could be seen by huge downside moves across the technology space while stocks of industrial companies, banks, airlines, leisure companies and others that have languished during the shutdown shot higher. While it is true that a vaccine would mean the economy could reopen and certain companies that were hated during the lock-down might suddenly see their fortunes change for the better. However, there is little doubt in my mind that a rapid rotation and repositioning by traders using ETFs exacerbated this rotational volatility. Further, plenty of stocks that are unlikely to see meaningful change in their fundamental outlooks got swallowed up in the moves. True, the market is dynamic and ever changing and prices change daily as new information is digested and expectations adjust. But it is the massive, synchronized moves of entire swaths of stocks that is a big tell that ETFs are driving stock prices more than stock prices are driving ETF prices. Several years ago when I was glued to a Bloomberg Terminal 15-18 hours a day I would often look at the top holders of the stocks of companies I was researching. What I regularly found was that the largest holders most of the stocks I looked at, were companies that sponsored ETFs. In fact you’d be hard pressed to find a single publicly traded stock that is not included in at least a handful of ETFs.


To be fair, I have exposed a significant personal bias with my commentary. I am a strong believer in “knowing what you own” so I am generally a proponent of investing in securities on their individual merits even if that means assuming individual company risk and needing to perform more extensive fundamental research. To be quite honest, in a market environment that is so dominated by the action of baskets and groupings of stocks, I think knowing what you own is as important as ever, else you risk getting caught in the confusing rotation and being susceptible to more frequent and regrettable trading mistakes due to loss of confidence and seemingly irrational price action.


There are many ways to achieve investment success and no single approach is guaranteed to be superior in any given market environment. ETFs and index funds have certainly established their place and can be useful investment tools when implemented both properly and judiciously. But there is a point where one should question whether the marginal benefits of the latest ETF creation better serves the individual investor or the sponsor who gets paid for creating it. And investors should remember that sometimes stocks go up and down for the wrong reasons.


Biggest vessel yet.

-David

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