Are trackers the latest bubble on the financial markets?

The growing popularity of trackers has triggered a fierce debate amongst investors. An analysis by Michael Burry has rekindled this debate in recent weeks. Michael Burry shot to global fame when he correctly predicted the financial crisis of 2007. You may know him from The Big Short. Since he has recently issued warnings about the growing popularity of trackers, reviving the term bubble, a brief analysis is definitely due.

What is going on, according to Burry? Given the huge amount of money being invested in these passive investment funds, he fears a serious crash. This would come at the moment that the stock markets' upward trend reverses and everyone heads for the exit. In his own words: the longer it goes on, the worse the crash will be. Is this analysis correct?

Before going into detail on this, let me briefly outline how a tracker or ETF works.

• As a passive investment fund, such a tracker actually does nothing but follow or track an underlying index. This underlying index may be a stock market, such as the S&P 500 or the BEL20. But it can also be a bond or commodities index.
• If the underlying index of a tracker rises, for example by 1%, the tracker will also increase by 1%. The reverse is also true. If the underlying index falls by 1%, the same thing happens to the tracker.
• A major benefit of trackers is their cost structure: you will often pay no more than 0.15% per year for the average tracker. That is one of the main reasons behind the immense popularity of trackers in recent years.
• A tracker can also be traded on a stock exchange instantly at any time. With a traditional fund you have to wait for the calculation of the net asset value every evening before you can trade.

A few thoughts on Michael Burry's comments:

• The core of Burry's argument is that prices of shares on the major, well-known stock market indices are being pushed higher by the constant flow of funds to trackers. He claims that as a result, there is no longer a link between the stock market price and the fundamentals of the companies making up the index.Our reservations: If this were the case, why then would we have seen major shares such as Kraft fall strongly this year (<20%)? We are also seeing the banking sector in Europe, which is traditionally a major weighting in benchmark indices, performing below par. In summary, it is hard, even impossible, to reconcile these price movements with the claim that investors in indices are driving the prices of "blue chip" shares ever higher.
• Burry also states that investors are no longer doing their homework. According to him, they are no longer looking at the intrinsic value of companies. As a result, there are new opportunities in certain underexposed asset categories. In his article, Burry refers to American “small cap value stocks”. These are smaller shares that are listed below their net asset value.Our reservations: We also find this argument against trackers problematic. When investors base their strategy on a selection of under-valued sectors or regions, this can be absolutely be implemented using trackers. Today, there are trackers for all significant regions, sectors, stock market capitalisation (large/mid/small caps). And these certainly allow a "value strategy".
• Burry anticipates a very strong downward correction, when the mood reverses. “The longer it goes on, the worse the crash will be.”Our reservations: Does that then mean that trackers are responsible for this? If investors suddenly begin to be concerned about economic reality and wish to reduce their exposure to shares as a result, they will do so regardless of their portfolio composition! Whether their portfolio consists of individual shares, traditional funds or trackers, they will still sell them!
• Another important point in the discussion about intrinsic value: it is actually evident from research that the vast majority of traditional, actively-managed funds do not succeed in beating their benchmark index. This requires further thought. The managers and analysts behind these funds do nothing but constantly review companies in order to calculate their correct intrinsic value. When they believe that this intrinsic value is too high/low they sell/buy the shares. But reality shows us that all this deep analysis frequently does not translate into an outstanding performance. And that's even without taking the costs of those funds (entry and exit fees for example) into consideration.
• In Europe, and certainly in Belgium, the vast majority of investors are still investing in individual shares or traditional actively-managed investment funds. Trackers (even though growth is very strong) still represent a very small slice of the pie, so we think it is an exaggeration to place the responsibility for the rise in the stock markets in recent years on trackers.Our reservations: would the central bankers at the ECB in Europa not have had a much greater influence on prices than trackers?
• We often get the impression that the criticism and bad news surrounding trackers is mainly related to their disruptive nature. For years, investors had no alternative. They could only invest in traditional funds. That immediately also meant they had to pay, often high, entry costs. Add to that the annual operating fees and the exit costs and the bill soon mounts up. Today, with trackers, there is an alternative: nowadays, investors can move into and out of specific asset categories in no time at all with very low fees. These days, the cost of the average tracker is not much over 0.15%. In the United States, there are even free trackers!

Those were our main reservations after the nth critical article about trackers. We are sure that more will follow.

In our opinion, trackers are the most significant financial innovation of recent years, certainly for those who do not have a fortune to invest, and for those who are not welcomed by the major private banks. With trackers, anyone can put together a wide, diversified portfolio at very low cost. In times of almost 0% interest on savings, this is a significant boost for anyone seeking extra returns!

Geert Van Herck Chief Strategist KEYPRIVATE