Index ETF For Passive Investing ( Not Anymore ? )

We often relate Index ETF as one of the asset class for “passive investing” and one of the main tenets of passive investing is the strategy of long-term holdings and less active trading. Because there are very infrequent buying and selling, fees are low. In short, this means you’ll lose less of your returns to management due to higher transaction cost in the long run.

But recent fund flow data seems to show in a different result as what we had always thought.

Traders Get Whiplash After Fastest Ever Fund Flow Swing From Euphoria To Despair <source:trulytimes.com>

 

“US equity funds and ETFs reported $26.87 Bil of outflows, the largest weekly outflow since December 2018 and the third largest outflow ever, more than reversing a $22.67 Bil inflow one week earlier.”

 

It seems that ETF no longer meant for “passive investors” but more for trading nowadays. New trading platforms with a much lower or zero commission have also contributed a lot to such huge fund flow in and out recently.

When It comes to trading commissions, Zero is the new normal, it makes “trading” of stocks so “affordable” and so “ easy”.

 

What zero commissions mean for stocks <source:yahoo.finance.com>

In late 2019, low-cost brokerage firm Charles Schwab announced that it would now offer zero-commission trades on stocks,(ETFs) and mutual funds on its platform. TD Ameritrade and E*Trade announced similar plans in short order. 

This helped fuel an influx of retail investors and a dramatic spike in trading volume. Charles Schwab and TD Ameritrade both added over 600,000 new accounts in the first quarter of 2020, and E*Trade added 363,000. 

“You could see more volume and more volatility the easier it is to trade those underlying securities, for sure,”

“People can trade much more quickly with the snap of a finger or a swipe on the screen and sometimes that may cause you to make decisions you don’t want to make and react emotionally”.

 

Diversification With ETF ( Not Anymore ).

 

ETFs are supposed to be the types of passive investing asset class with characteristics of low cost and diversification. When you invest in stocks, bonds or any other security on a singular basis, it’s up to you to choose which ones you want and when to buy and sell them. But because investment professionals manage the aforementioned group of funds, you’ll reap the rewards of strong diversification and asset allocations without getting your hands dirty. 

But with the increase of price and market cap of just a few "popular" stocks in a certain index, the total weightage of the index will concentrate on these few stocks only. For example, in below NASDAQ 100 component stocks, the 7 biggest market cap stocks accounted for  52%  of total weightage of this index, which tracks closely by most of Fund ETF ( e.g Invesco QQQ ETF ). 

Similarly, you may find the same situation happens in our STI Index, where 9 stocks ( i.e 3 Big Banks and 6 REITs)  accounted for around 51% of the total index weightage.    

 Components of the Nasdaq 100

#	Company	Symbol	Weight
1	Apple Inc	AAPL	13.321
2	Microsoft Corp	MSFT	10.91
3	Amazon.com Inc	AMZN	10.755
4	Facebook Inc	FB	4.25
5	Alphabet Inc	GOOGL	3.442
6	Tesla Inc	TSLA	3.359
7	Alphabet Inc	GOOG	3.344
8	NVIDIA Corp	NVDA	2.812

 

 

Capitalization-Weighted Index <source:Investopedia.com>

 

The Downside of Capitalization-Weighted Indexes

 “Over time, companies can grow to the extent that they make up an excessive amount of the weighting in an index. As a company grows, index designers are obligated to appoint a greater percentage of the company to the index, which can endanger a diversified index by placing too much weight on one individual stock's performance.

Also, index funds or exchange-traded funds buy additional shares of a stock as its market capitalization increases or as the share price increases. In other words, as the stock price is rising, the funds are purchasing more shares at higher prices, which can be counterintuitive to the investing mantra of buying low and selling high.”

 

Will Index Fund / ETFs Cause The Next Financial Bubble?

 

 Back in September 2019, Michael Burry predicted an index fund bubble. Burry, who had correctly predicted the derivatives-based Financial Crash in 2008– and whose character was the star of the film The Big Short, has warned that Index Funds may be setting up a market bubble in equity markets, which may end badly for the large number of people now invested in index-tracking funds. 

There are multiple reasons why ETF and Index Investing are getting popular. The two most prominent are probably ease-of-investing ( easy to trade) and with booming low-cost trading platforms.

One of the main problems for index investing is the valuation differentials between stocks that are represented in indices and those that are not. This may be the most convincing evidence that indices are driving a capital inflow into stocks that may not be linked to the true value of those stocks. Why is it that similar stocks inside an index are valued higher than those outside? One ready explanation is that index fund investors are injecting cash and demand where it otherwise wouldn’t exist. This can be seen when any stock being announced to be included into a certain index, the price may shoot up even before the stock started to be listed onto that particular index.   

 

“Fire!” in a theatre

 

“ The theatre keeps getting more crowded, but the exit door is the same as it always was…..”

 

What If Everyone only invested in Index ETF? <link>

 

 As above mentioned, when an index investing became more and more popular, the fund flow in and out will be huge and enormous at any point in time, it could cause very high and extreme volatility to the market, as what we have seen in NASDAQ recently.

When there is too much of money concentrated in just a few (Ultra/Big-Cap) stocks like Apple or Amazon, imagine like when there is “FIRE” in a theatre, what will happen when everyone trying to exit the market at the same time. Yes, it may cause a “systemic risk” which could destabilise the whole market like a stampede.

 

Lack of Price Discovery <source: Investopedia.com>

 

“One of the risks in Index Investing that some analysts fear is a situation where a vast majority of investors turns to passive indexed investing utilizing ETFs. If a preponderance of investors hold ETFs and do not trade the individual stocks that sit inside of them, then price discovery for the individual securities that constitute and index may be less efficient. In the worst case, if everybody owns just ETFs, then nobody is left to price the component stocks and thus the market breaks.”

 

What is “Price Discovery”? <source:Investopedia.com>

Price discovery is the overall process, whether explicit or inferred, of setting the spot price or the proper price of an asset, security, commodity, or currency. The process of price discovery looks at a number of tangible and intangible factors, including supply and demand, investor risk attitudes, and the overall economic and geopolitical environment. Simply put, it is where a buyer and a seller agree on a price and a transaction occurs.

 

  

Index Funds Massive Bubble Will Create Epic Stock Market Crash And Meltdown <Video by Sven Carlin (P.H.D)>

Not All Index Are Created Equal <Link>

<Data Source: YahooFinance.com>

Of course, every bubble created by huge “mania” and “irrationality” and also you need a good “ story” behind that to create the “mania”, like what happens to NASDAQ or TESLA like of company.

I know many were disappointed by severe under-performing of STI index vs other major indexes. We simply don’t have FAANG+T or ATM+X likes companies to be listed here in SGP, so what do you think can be the “story” behind the STI Index? To make the STI Index Great Again !!

 

Cheers !!

 

STE

 

 

Quote Of The Day :

 

“Keep Your Face Always Toward The Sunshine - and Shadows Will Fall Behind You” by Walt Whitman