Could ETFs crash the market? Maybe – but that’s not what you should worry about

The head of one of the biggest exchange-traded fund (ETF) providers in the world has just warned that ETFs could leave a lot of investors nursing heavy losses if the markets fall.

That sounds like an interesting admission from a big player in the industry.

Does he have a fair point? And if so, what's the solution?

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A Gerald Ratner moment for ETFs? Not so fast...

Martin Flanagan is the president and chief executive of asset manager Invesco. Invesco is the fourth-largest provider in the exchange-traded fund (ETF) market (although in terms of assets under management, it's a long way behind the big three BlackRock, Vanguard and State Street).

Yet Flanagan has just come out and warned that all of the investors who are pouring money into ETFs that track indices such as the S&P 500, run the risk of making huge and unexpected losses if markets slide.

The issue, notes Flanagan, is that the big indices are market-cap weighted. In other words, the stock with the highest market value is at the top, and the one with the lowest value is at the bottom. In turn, that means the biggest stocks also account for a far bigger proportion of the index than the bottom stocks.

For example, notes the FT, the big tech giants Alphabet (Google), Apple, Microsoft, Amazon and Facebook together account for nearly 12% of the S&P 500 index.

What Flanagan is worried about is this: people might buy an S&P 500 tracker, thinking that they have a very diversified portfolio with exposure to a wide range of stocks and sectors. Instead, of course, they're extremely top-heavy in technology, and pretty light on anything near the bottom 75% of the index.

As Flanagan puts it: "The reality is that they are turning more and more into momentum plays. You are ending up with a disproportionate amount of your portfolio in the biggest stocks." Put into plainer English, Flanagan is making the argument that a lot of money is flooding blindly into the biggest stocks in the market, regardless of valuation.

The risk is that as soon as that turns around, the money will flood out as fast as it flooded in, and you'll have a crash which is exaggerated by the over-concentration that ETFs have enabled.

He's got a point. As the FT points out, "the ten largest stock ETFs in the US are all weighted by market cap". And you might think, looking at the headline ("ETF provider head warns on concentration of holdings") that it's an intriguing warning for someone in his position to make.

However, Flanagan has not had a "Gerald Ratner" moment.

What you have to remember is that there are various different types of ETF in the market, and not all of them simply track an underlying index like the S&P 500.

And not coincidentally (a cynic might suggest) Invesco is a big provider of solutions to this particular problem. The fund group has just paid a pretty penny for Guggenheim, which is a significant player in the "smart beta" market creating ETFs that choose stocks in a range of different ways, all of which are meant to be smarter than market-cap weighting.

The perfect index doesn't exist

So does Flanagan have a point? He does. But that doesn't necessarily mean that he has the solution to the problem.

Market-cap weighted indices are undoubtedly an imperfect way to invest. You have to remember why these indices were put together in the first place. They were not designed to be financial vehicles in themselves. Instead they were meant to give an "at a glance" view of how a country's biggest companies were doing. This is why the biggest ones are named after media companies.

For example, take the Dow Jones index (which isn't market-cap weighted, but instead uses an even less helpful methodology). This was created in the late 1800s by Wall Street Journal editor Charles Dow. The point was just to give a view of stockmarket activity as one aspect of the wider economy. The idea was not that you'd buy each of the 12 stocks (it started out with 12, rather than 30) in proportion to their holdings in the index.

So the point is, many of the indices that are now used as benchmarks and as the underlying components for ETFs and other tracker funds, were not designed with this in mind.

As it happens, "momentum" is a perfectly respectable strategy. Momentum is one of the few factors that academics agree can beat the wider market over time. Market-cap weighted indices aren't exactly momentum plays (they're not as aggressive as a true momentum strategy), but they're along the same lines you are putting more money in the most popular stocks and less in the least popular ones. You are buying what's going up and avoiding what's going down.

The problem with a plain vanilla market-cap weighted ETF, though, is that it's only a momentum strategy while you're in a bull market. Once the market turns, your ETF is no longer a momentum fund instead it's a long only fund in a bear market. And that means you just lose a lot of money.

The promise of "smart beta" is to create a better passive product a fund that uses a more sensible selection process to choose the underlying stocks. It is still mechanical you don't have an "active" manager picking and choosing stocks on a discretionary basis. But the criteria might involve things like valuation (price/earnings ratios) or ensuring that no single stock has more than a 5% weighting in the index.

That sounds like a good idea. And some of the ideas behind smart beta are indeed worth looking at.

But the trouble with smart beta is that you start to move away from what makes ETFs and passive funds so great.

When Jack Bogle set up the first passive fund in 1975, his philosophy was very simple. Beating the market is hard. So for the average buy and hold investor, it's better to buy and hold the market rather than worry about picking individual funds.

But more than that, Bogle also understood that the big problem for human beings is not just that we can't pick the active managers who will outperform. It's that we can't stick to our guns. Not only will we pick dud managers, we will dump them and swap to apparently better managers, just in time for them to turn around and start underperforming too.

In other words, investors are their own worst enemies. Activity, for the average investor, is value destructive.

The beauty of a simple market-cap weighted fund is that it goes up and down with the market and it does so cheaply. It's not meant to beat the market and it is not meant to save you from bear markets either. The point is that over the long run a couple of decades at least you will do better than if you'd stuck your money in a savings account.

Smart beta has some interesting strategies, and I'm not against it at all. You might prefer to buy and hold a "value" ETF rather than a market-cap weighted one. But smart beta funds are more expensive so they immediately reduce one of the big advantages of passive investing. And more importantly, they introduce complexity and the opportunity for over-activity.

You start thinking: "Well, I'll buy and hold this value fund. Oh but wait, it feels like a momentum world today. Maybe I should buy the momentum one, but then trade into value when the market looks like it's about to turn. How will I time the market? The next time the FTSE 100 falls by 5% I'll shift into the value ETF. Unless something else comes along."

And before you know it, you're back to square one chasing performance like a dog chasing its tail.

I have nothing against smart beta. And I do also believe that when the next crash comes, the amount of money poured into index-tracking ETFs will likely exacerbate the falls (just as I suspect they've helped to keep the market as overvalued as it currently is).

But just because an S&P 500 ETF might be a bad investment right now, doesn't mean that vanilla ETFs are a bad thing, or that buying a smart beta S&P 500 ETF is an any wiser idea.

There is no miracle financial product. Keep your costs down. Don't over-trade. Shun complexity. Understand exactly what you own and why you own it. Following those principles is more important than fretting about exactly which shade of fund to own.