Lately there has been significant discussion about the relative merits of index funds versus active management. Regardless of what you think of each style of investment, the metric for measurement the effectiveness of each should be a full market cycle.  The US domestic market has had a good run, having had little volatility and a tail wind from the Federal Reserve.  However, Forbes [] noted the potential pitfalls with passive investing, including 1) Misallocation of Capital; 2) Asset Price Distortions; 3) Systemic Risk Factors; and, 4) Fiduciary Duty of Care.  We strongly recommend at this point in the market cycle, with the Federal Reserve slowly increasing rates and unwinding Quantitative Easing, that investors be aware of these issues.  In the current environment, we believe the quality of the equities purchased will be increasingly important, which can be further explored in the article.  To give you a taste of what David Trainer states in the article: “With the Case-Schiller CAPE P/E ratio recently crossing 30x for only the third time in history (the other two being 1929 and 2000), I think it’s prudent to consider whether broad overvaluation is an unintended consequence of large, uninterrupted inflows into ETFs and other passive index products.”  And “…of the $6.7 trillion in enterprise value added to the S&P 500 since 2013, I estimate $418 billion (6%) is attributable to NOPAT growth (at the 2013YE EV/NOPAT multiple of 18.8x), $1.2 trillion (18%) is attributable to an increase in net debt, and $5.1 trillion (76%) is attributable to the increase in the S&P 500’s aggregate EV/NOPAT multiple to 23.9x currently (from 18.8x at the end of 2013).”  Please read the article to get a full flavor of the significant and often unstated risks of passive investment.

This [] Financial Times recently interviewed a number of investment experts on the trend towards passive investing.  [article snip] Years of large net inflows into indexed-tracking products has encouraged a momentum effect. “Winners keep on winning and losers keep on losing,” as FT columnist John Authers has put it. Whereas active managers might buy or sell equities based on fundamental factors such as value, much passive money is effectively “blind” in that it buys assets according to the rules of the index or theme.  Markus Stadlmann, chief investment officer of Lloyds Private Bank, agrees that this automatic buying activity is a problem. “[It’s] obviously wrong because it takes the valuation of the companies to a level that is not appropriate, and it also opens up the stocks to arbitrage.”  Steven Bregman, the co-founder of US-based investment adviser Horizon Kinetics, is critical of the distortions being created by the rise of ETFs. “There is a law of supply and demand, and if something gets overdone, and too much money flows into one place, you get distortions,” he says. “This particular distortion, and there are numbers to show it, is probably the largest in history.”[end snip]  The article also notes that the current price-to-earnings ratio for several indices, including the S&P 500, sit above 20, a level at which past experience tells investors to be conscious of the downside.

Finally, risks should be kept in mind when investing in ETFs.  Per the article, understanding ETFs requires that investors understand: 1) Counterparty Risk, 2) Tracking error, 3) Liquidity risk, 4) Sampling, 5) Asymmetric information, and 6) Asset exposure.

Written by: David Stewart, Co-chair of the UUA Socially Responsible Investing Committee and Lucia Santini, UUA Financial Advisor