Are new ETF launches a sign that markets are overheated?

published 1 September 2017

Here's a warning sign that a market is overheated: new fund launches. In the year before the dotcom bubble popped in 2000, UK tech fund launches rose nearly tenfold. It's a key problem with the financial industry a fund is easy to sell when a theme is popular, but by then its best days are behind it and its worst typically just ahead. The equivalent indicator today? Exchange-traded funds (ETFs). ETFs are easier to establish than traditional funds, so hot new sectors can be targeted rapidly. ETFs are also increasingly the go-to option for investors more than $250bn went into ETFs in 2017's first half, compared with $81bn for mutual funds, notes researcher FactSet.

There are many examples of ETF launches as contrarian indicators. The Global X Lithium & Battery Tech ETF (NYSE: LIT) launched in 2010, when the market was last getting excited about lithium, a key part of electric car batteries. In the six months following the share price went from around $33 to $45. Then, for a long five years, it slid, hitting a low of below $18 in early 2016. It only regained the $33 mark last month, now that lithium is "hot" again. Or there's the VanEck Vectors Uranium & Nuclear Energy ETF (NYSE: NLR), whose August 2007 launch coincided with the uranium price hitting a record high, then collapsing.

This is, of course, anecdotal data (often the case with contrarian indicators). Not every thematic ETF is a "sell" indicator a 3D printing ETF (NYSE: PRNT) launched in mid-2016 by Ark seems to have caught the once much-hyped sector at the tail end of its post-2014 crash. And while the cybersecurity ETFs HACK and CIBR launched in time to catch a major correction in mid-2015, they've made strong comebacks. So adding ETF launches to your collection of early warning signals makes sense just don't rely on them in isolation.

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Looking at a list of 2017 launches, the most obvious thing to be wary of is "smart beta" (see below) and US stocks in general. There's nothing wrong with smart beta strategies in theory, but the fact that issuers are finding so many different ways to slice a fundamentally overvalued cake the US stockmarket suggests that investors are getting desperate in their quest to squeeze some value out of equities.

As for specific sectors, ProShares in July registered plans to launch "ultrashort" ETFs aiming to profit from the death of bricks and mortar retailers a sign that this beaten-down sector may have hit the bottom. Finally, several pending bitcoin ETF launches are only being held up by regulatory queasiness. Don't be surprised if their eventual launch coincides with the collapse of the crypto-bubble.

Smart beta funds aim to combine the best aspects of passive and active management. Like active funds, they aim to beat the index. However, they do this by eliminating any element of discretionary human judgement. Instead, a smart beta fund uses a mechanical set of rules to choose stocks that are expected to outperform the index. By avoiding using an expensive human manager, smart funds cut costs, and reduce the risk that the fund will shift its style over time.

The simplest smart beta funds build bespoke stock indices, by re-weighting existing indices using their own criteria. For example, some funds weight each individual share in the S&P 500 or FTSE 100 equally (rather than by size). A similar strategy is to use earnings or dividends to weight the portfolio. This approach implicitly aims to boost the proportion of cheap and smaller companies in the index relative to traditional indices, which are dominated by large firms. A more "active" version of this strategy is to cut out expensive shares altogether, by only picking stocks that meet certain criteria, such as those with low price/earnings ratios or above-average dividend yields. Some of the most elaborate smart beta funds run complicated screens, using a variety of criteria, to rank shares. The idea is to ensure that the selection isn't skewed by one single metric.

Critics argue that all three types of smart beta funds have big potential downsides. Equal-weighted indices need to be rebalanced frequently, which raises costs. Funds focusing on one criterion run the risk of becoming overly concentrated in one particular sector. And those that use multiple criteria are frequently just as expensive as active funds, and often even less transparent. The key as with any fund is to understand what you're buying.

John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.