The ETF Correlation Bubble: A Powder Keg?

–Kristi Kuechler, President, FOX Private Investor Center

Excerpts from “A Visit with a Mainstream Value Manager and Growth Manager,” by Steven Bregman, President, Horizon Kinetics LLC

Based on financial news articles and television shows, everyone should be aware that money is being constantly withdrawn from active managers and placed into ETFs and other index funds. Undoubtedly, active managers are striving with even greater urgency to beat the indexes against which they are judged, seeking some edge. Here are two typical large-company, blue-chip strategies. One is value oriented, the idea being that the manager selects, only from within the benchmark index, in this case the S&P 500, those stocks that are the least expensive. It is generally agreed to be a lower-risk approach.

The other basic strategy, of course, is growth oriented, and it also chooses stocks only from within the S&P 500. It presumes that even if a higher price is paid, the higher growth rates of those companies will more than make up for the greater valuation risk. Let’s look at two such funds. Both have been very successful in terms of asset gathering, with about $15 billion in AUM apiece.

The companies in the value fund trade at 18.0x trailing earnings and at 2.0x book value. Whether one thinks this is expensive for a value fund or not, it is certainly quite a discount to the growth fund P/E of 23.7x and price/book ratio of 5.0x. So at least the valuations makes sense relative to one another.

The Question Is: Would You, or Should You, Dismiss One or Both of These Value and Growth Managers? Would You Even Own Such a Fund, Knowing their Financial and Tech Sector Weightings?

Some information before you make a decision: the preceding discussion engaged in a small deception. These funds are actually the iShares S&P 500 Value ETF (IVE) and the iShares S&P 500 Growth ETF (IVW). So these are not really actively managed funds run by two different portfolio managers desperate to keep assets from leaving, they are index funds desperate to bring more assets in.

Here’s more data. These funds do give a nod toward active management in that they are what are known as “smart beta” funds, which has become the fastest growing category of ETFs. The idea of smart beta is to isolate a particular variable that has been demonstrated in statistical back-tests to add a valuable characteristic. In the case of these two iShares ETFs, a stock is determined to fall into the value or growth category based on its price-to-book value ratio. Essentially, if all stocks are ranked according to their book value multiple, those with price-to-book-value ratios below the median or middle value are known as value stocks, and those with ratios above the median value are the growth stocks.

In the end, it’s all attributable to incentive structure, the ETF fee price war created by Vanguard, which has driven fees down to several basis points on mainstream funds, and the need by competitors to create differentiated products that can, for a time, charge higher fees. That is a topic for another discussion.

To see the full agenda for the 2017 FOX Autumn Global Investment Forum, click here.