I have to say that Vincent Deluard at US based outfit StoneX is fast turning into arguably the most articulate and readable quant expert writing today. Every few months he comes out with a great paper which nicely sums up the sum of market fears and hopes. Last time it was a cracking note on the anti-jobs bias of many ESG and Tech businesses. This time in his latest note, amusingly called PASSIVE ATTACK, JURASSIC PARK, AND THE NASDAQ BUBBLE, he takes aim at the biases emerging from the growth in ETF flows and the challenge it poses to classic passive academic research by the likes of Bill Sharpe (especially his The Arithmetic of Active Management).

Deluards’ main worry is one that none of us would disagree with, namely that you can’t really own ‘the market’ in the technical sense because of all sorts of boring reasons. Thus, you end up with an approximation of the market which finds its way into an index which will then find its way into an approximation of the index via an ETF. Along the way there is plenty of things that can go wrong.

But his key point is that if you look at ETF flows, you end up with a very different ‘market’ than the real one. This is indisputably true, though it has always been true for active funds as well in their hayday! Still, the sheer weight of money pouring into ETFs mean that these supposedly passive funds are becoming “an unwilling active participant in the process of price discovery”. Deluard’s key insight is to use a Bloomberg feature to output the entire holdings of all ETFs and then build up a flow weighted ETF portfolio.

Using this method, we discover that there’s a strong bias towards tech stocks which are hugely favoured by the most popular ETFs. According to Deluard “technology stocks received 36% of all ETF flows since 2019, while they account for just 26% of the total capitalization of the market. Conversely, financial stocks have received just 1.8% of ETF flows since 2019, while they account for just 10.2% of the total capitalization of the market. As shown by the blue bars, these trends have accelerated in 2020: the rotation towards passive funds and ETFs is increasingly skewing the market towards the tech sector, which is consistent with the parabolic rise of the Nasdaq in 2020….Microsoft, which accounts for 4.2% of the Russell 3,000 index’s capitalization, received 8.1% of ETF flows this year. All the big tech companies received a bigger proportion of ETF flows in the past two years than their market cap weights. Conversely, large value stocks, such as Walmart or Berkshire Hathaway received less ETF money than they should have based on their index weights”.

The chart below shows these stock tilts from ETF flows on a company by company basis.

At this point it’s crucial to keep some perspective – ETFs may be popular but they aren’t in truth the major component of market liquidity and trades. For almost all large caps, all ETF flows for the year consumed less than one day’s worth of trading volume. But at the margins ETFs can make a difference – Deluard uses the metaphor of lots of droplets of rain turning into small torrents that “eventually erode soaring mountains into plains”.

So how do these popular ETF trades distort the wider market? Deluard identifies three key concerns:

  • ETFs are price-insensitive buyers and sellers: price-driven buyers will typically spread their orders over time to minimize their market impact. On the contrary, ETFs need to track their benchmarks at all times, regardless of liquidity conditions. For example, outflows from XLF (Financial Select Sector SPDR Fund) and leveraged ETFs would lead to precipitous drops in the last hours of trading during the 2008 crisis as these funds needed to sell at the close, even though no counterparty was willing or able to buy.
  • ETF demand effectively acts as a buyback program for large tech stocks: for example, Microsoft received $4.7 billion in ETF demand this year is comparable to the $5.7 billion buyback it completed last quarter. The $970 million of ETF flow which went into Adobe is more than the company spent on stock-based compensation last year. In other words, steady ETF demand allows big tech companies to issue shares to their executives and employees “for free”, which in turn allows them to conserve cash for investments, acquisitions, and R&D.
  • The source of ETF inflows matters as much as the size of their flows. ETF money does not grow on trees. As I explained in “Dumb Alpha: How To Be an Intelligent Investor in a Stupid Age”, the money going into U.S. equity ETFs mostly comes from active, high-fee mutual funds. These funds tend to be overweight small cap and cheap stocks in the hope to capture the size and value premia.

This all makes sense and fits in with the growing moral panic about the remorseless rise of the Robin Hood generation. I do not doubt that these are all perfectly valid concerns but I still fall back on the old adage of not shooting the messenger. ETFs are but one product structure that gives expression to more structural behavioural forces driving modern markets, namely 1) too much central bank money sloshing around 2) inequality in wealth pushing more money to a select group of investors with huge amounts of capital to play the markets and momentum and c) the desire of many investors to chase momentum. Sure, ETFs alongside options, spread betting and any other product structure allows these impulses to find a home and easy liquidity but there are much more important processes at work here.

What is interesting though in the Deluard note is the less eye-catching observation that ETFs also deliver a subtle tilt towards quality growth strategies. In truth, I had always thought that was mostly powered by active fund managers who to a man and woman seem to talk endlessly about quality stocks until they are blue in the face. What investors are looking for here is quality growth in the dividend yield, not the absolute payout.

Deluard finds that when looking at ETF flows “the price-to-book value ratio of the flow-weighted generic ETF portfolios about 14% higher than that of the Russell 3,000 index. Its payout ratio is 47.6% versus 40.8% for the Russell 3,000 index,  reflecting the popularity of income funds and the fact that ETFs tend to overweight dividend sectors, such as utilities and real estate.

At the holding level, this activity results in net selling of big tobacco (the largest weightings in DVY) and net buying of big tech (Microsoft is the largest holding of VIG). Intel also received 1.1% of all ETF flows since 2019 while it accounts for just 0.5% of the Russell 3,000 index’s market capitalization.

Again, I’d make the observation that ETFs are but one product which drives this quality dividend growth trend, with active managers much more predominant in my view.

The big point here though  is that ETFs will simply help exacerbate wider market turns when they eventually emerge. As Deluard observes the “concentration of ETF flows into a handful of stocks with similar characteristics (high valuations, high margins, small but growing dividends, stable earnings, tech orientation) means that the sector will be very vulnerable when ETF flows reverse.”.