Millennials Buying Smart Beta ETFs

05/15/2017 2:50 am EST

Focus:

Don Kaufman

Co-Founder, TheoTrade

Sometimes stocks don’t rebound. This basic concept  is lost on investors who have started  in the past 8 years because they’ve never experienced a crash, asserts Don Kaufman, Co-founder of TheoTrade.

The proliferation of ETFs has been behind the rapid increase in stocks this bull cycle and particularly responsible for the rally in the last twelve months which has been fueled by mom and pop investors. The number of ETFs has doubled in the past twelve months to 2,500, but that doesn’t tell the true story because most investors are piling into the biggest ones like the S&P 500 Trust ETF (SPY) which represents the S&P 500.

It makes sense that the top ETFs are getting most of the money because mom and pop investors aren’t going to understand esoteric ETFs created for a small subset of investors. The top 50 ETFs account for 67% of total ETF assets.

The chart below breaks down the concentration of assets within the most popular ETFs. Not only are investors almost all long and piling into ETFs, but they’re also piling into the same ETFs. This group think mentality feels good at the moment, but will have disastrous consequences.

Investing based on conventional wisdom will get you killed. Even if you aren’t trying to gain alpha by buying ETFs, you still aren’t immune to the risks associated with buying into a strategy that almost everyone is executing. Besides central bank intervention, the other way bubbles are formed is when people think that they aren’t taking risk because the strategy is popular. That’s when the most risk is taken and the biggest losses occur.

chart 1

The latest ETF buying by mom and pop investors can be seen in the chart below. It’s the latest bump up in valuations we’ve seen in the past few months since the election. The chart below shows the stock market capitalization compared to the GNP. It is about to surpass the bull market high in the 1990s which peaked in March 2000 at 180%. GNP is the sum of personal consumption expenditures, private domestic investments, government expenditures, net exports, and any income earned by residents from overseas investments, minus income earned within the domestic economy by foreign residents.

The reason stocks are expensive compared to the GNP is because of excess speculation and because margins are very high on an historical basis.

Margins are high because of low corporate income taxes and because some firms like Google (GOOGL) and Apple (AAPL) have created temporary monopolies for themselves. This chart ignores margins because it assumes they mean revert. Margins have historically always mean reverted, but bullish investors say this time is different. They are relying on the big tech firms to fend off the competition and maintain their high margins.

To me, that seems like a foolish bet because technology is the industry with the most disruption. It is unknown how a company will outmaneuver Google to change the game, but it will happen.

chart 2

The charts below show where investors have been putting their money. Besides index funds, another class of ETFs which has become popular is called smart beta.

Smart beta is a spin on passive investing. The ETFs have low fees which are slightly above that of index funds. They are factor investments which aim to acquire alpha by focusing on a specific style such as low volatility. The more popular they become, the less alpha they’ll be able to generate. It’s tough to make a wide-ranging claim on how they’ll all perform because the factors can be anything. They’re great for firms like BlackRock because if the fund underperforms, it’s the investor’s fault. The investor can’t fire the fund manager because it’s a passive index.

As a general assertion, I would say trends in investing strategies come and go, so this new trend probably won’t last. The worst case-scenario would be if factors don’t work out as expected. The low volatility factor that many millennials using “robo advisors” are piling their money into may not stay true to its name when the market becomes highly correlated in a sharp correction.

As you can see in the first chart, the percentage of ETF assets which are in smart beta funds has increased since 2009.

The second chart shows the survey results when investors were asked if they use smart beta. As you can see, the usage has gone up a lot since the early 2000s.

The third chart shows the proliferation of low volatility ETFs which are one example of a smart beta ETF.

The fourth chart shows that forward P/Es of low beta firms have increased as compared to high beta firms as smart beta investors pile into the low beta funds. This can create bubbles in low beta stocks and opportunities in high beta firms. If enough people buy low beta firms, they end up becoming high beta as their valuation exceeds their intrinsic value.

chart 3

The other investment millennials have been piling into lately is Snap (SNAP) stock. The screenshot below is from Closing Bell’s app which looks at the stocks purchased with the Robinhood trading app. Millennials have been taught by the market to buy the dip even though the firm spent $2 billion on stock based compensation. Clearly, they don’t care as they pushed the stock up 6% on Friday.

When you trade stocks like Tesla (TSLA) and Snap, you must recognize that the owners of those stocks don’t care much about profits. Therefore, when a bad report comes out, it’s tough to determine what these irrational investors will do. If I had the numbers ahead of time, I still wouldn’t be able to predict how the stocks would react.

chart 4

Conclusion

Investors are very bullish on stocks, but don’t want to pay fees. They figure that if fund managers are just buying the dips in stocks, they can do that themselves. In a sense, they are correct because if a fund manager is simply going long high beta stocks, then it’s silly to pay the manager high fees. That being said, the buy the dip strategy is not a real investing strategy.

Sometimes stocks don’t rebound. It’s a basic concept which is lost on investors who have started investing in the past 8 years because they’ve never experienced a crash.  

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