ETFs may cause the next recession

Passive investing may not work as planned in a downturn

Money changer holds U.S. dollar banknotes as he counts other currency banknotes at Grand Bazaar in Tehran (photo credit: REUTERS)
Money changer holds U.S. dollar banknotes as he counts other currency banknotes at Grand Bazaar in Tehran
(photo credit: REUTERS)
The Salem witch trials started in February 1692. For a little over a year, the general population thought that witchcraft was a real phenomenon, and communities were happy to sentence friends and family to death by trial. This seemed like reasonable behavior because everyone was doing it. In May 1693, almost like magic, the greater Salem area was no longer in an intellectual fog. They discovered that following the crowd could have some self-inflicted, unintended consequences.
What is passive investing?
It all starts with a market index. A market index is, at its core, a set of rules that creates a list of stocks. One of the most famous indices is the S&P 500 Index. For a company to make the list, it needs to be one of the 500 largest publicly traded companies in the US. Another is the Russell 2000 Index, which consists of the stocks ranked from number 1,000 to 3,000 by size.
Indices were originally used as a comparison for part of the market. If, for example, you invest in large companies, you would want to see how you measure up against the S&P 500. If you invest in small US companies, you’d measure performance compared to the Russell 2000.
Over the years, the financial industry has created products like exchange-traded funds, or ETFs, and index funds that simply buy the stocks in the index. While at first indices were a point of comparison, now they could be the investment itself.
The rise of passive investing
In 2009, about 25% of investments were managed passively. Since then, there has been a significant move toward passive investing. This trend brought the market to a point where almost 50% of the market (over $3 trillion) is passive.
This type of investing is great for the individual investor. For starters, fees are generally minimal. If virtually no work is going into choosing the investments, you shouldn’t be paying for it. The second benefit is you know what you’re getting. When you buy VTI (Vanguard Total Stock Market ETF) for example, you know that you are getting exposure to the entire US stock market.
But not all is bright in passive land.
How does the market work?
The financial markets are just that, markets. They are a place where buyers and sellers meet to exchange (fractional shares of) companies for money. Most market participants have trouble eliminating emotion from their decisions, so they buy and sell on rumor, skipping in-depth analysis. It’s hard to believe that any company gains or loses 2% or 3% of real value in a single day, yet prices bounce around in those magnitudes all the time. Price is what you pay for an investment, and it includes the seller’s erratic emotions. Value is the company you’re buying. Over the short term there can be vast differences between price and value but over time value sets the tone.
Blue-whale investing
Passive investors don’t look at companies’ value. In fact, they don’t look at companies at all. Like a blue whale swims around eating whatever is in its path, passive investors buy whatever crosses their paths if it matches the index criteria.
Over time, passive investors are stretching the link between price and value like a rubber band. As more people jump on the bandwagon, prices stretch the tether to an extreme. The farther the rubber band is stretched, the harder it snaps back.
Hotel California
The other main risk is liquidity. Think of a live concert or sporting event. The ETFs and index funds are analogous to watching the event on TV at home. The problem starts when the concert is over and you discover that in order to leave, you need to stand in heavy traffic for hours on the way to bed. Passive investors may discover that when the party is over, just like Hotel California, “You can check out any time you like, but you can never leave!”
Why will passive investing cause problems when you want to leave and take your money elsewhere? Take Axcella Health Inc. (AXLA), the smallest stock in the Russell 2000, for example. It trades about 28,000 shares per day, yet passive products own 3.5 million shares. This means that it would take passive investors more than a full day of trading to reduce this position by less than 1%, and even that is optimistic, assuming that buyers continue to show up and that passive funds are the only sellers in the market at the time. Now remember that there is no judgment involved when passive funds sell. They must sell at any price once the individual investor sells. “Sell at any price” is not a great strategy to make investment profits, and what’s true for Axcella is also true for bigger stocks, just with bigger numbers and bigger losses.
Living in a fog
Just like in 2007-2008 and in the 17th century, faulty ideas can be stretched until they break. You can wrap and re-wrap a financial asset, but economic reality cannot be ignored. Next time you’re offered an ETF, don’t forget to think of an exit strategy.

The writer is the CEO of ZUZ Capital Fund, a long-term, value-driven investment fund.