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Market Update for May 2017 – Are ETFs WMDs?

By Isaac Schweigert | June 14, 2017

Stock markets were generally positive in May, but the TSX ended its record breaking streak of positive months.  Are ETFs really the weapons of financial mass destruction that some critics claim they are?

 

May 2017 Market Performance

All index returns are total return (includes reinvestment of dividends) and are in Canadian Dollars unless noted.

 

*Absolute change in yield, not the return from holding the security.

 

The S&P/TSX Composite finally broke its record-breaking fifteen positive months streak, losing -1.3% in May.  Meanwhile, in the US the S&P500 was up +1.4% and European stocks were up +1.9%.  Emerging market stocks performed even better at +2.3%.

On the bond side, the broad index of Canadian bonds, FTSE TMX Universe Bond Index was up +0.9% for the month, while the short-term bond index was up +0.2%.  US bonds also performed well, with higher rated credits performing the best.  High yield bonds were also positive, while emerging market bonds took a breather after a strong start to the year and were down -0.4% in May.

Oil was down another -2% in May, bringing the YTD return on oil to -10%.  Gold was up +0.3% for the month and is now up +10.4% so far in 2017.  The broad Bloomberg Commodity Index was down again at -1.4%.

The Canadian dollar gained strength in May against the US dollar, finishing at 1.35 to the USD.  Against the Euro, the Canadian dollar slipped -1.8% to 1.52 to the Euro.

Commentary – Are ETFs WMDs?

Over the past few months it seems as if the negative press around ETFs and passive investing has been multiplying.  Often the criticism is coming from those that have a vested interest in something else: actively managed funds.  One even called ETFs a weapon of mass destruction, something that Warren Buffet once rightly called derivatives.  According to Bloomberg data, in the US, ETFs only account for about 7% of the US stock market’s value, and that figure includes actively managed ETFs.

One of their criticisms is that as ETFs hold more and more of the stock market’s value, fundamentals will no longer matter.  When money comes into an ETF, the ETF has to buy more of the stocks that make up the ETFs holdings, regardless of the valuation of those stocks.  But, how is that any different from investors that buy stocks for reasons other than fundamentals?  For some investors it usually is: “Does the company make any money?  No, but that’s not a problem, as long as someone will buy the stock from me at a higher price then who cares if the company makes money?”  The flipside is there are ETFs that use a smart beta, or fundamental indexing strategy.  ETFs that follow that strategy do look at the fundamentals to avoid buying expensively valued stocks.

Another criticism is that that the more ETFs there are, the more that stocks will move together, or to put it another way, the dispersion among stocks will decline.  But this isn’t something that ETFs will necessarily be the cause of.  Over the past 15-20 years the investment industry has become more and more computerized and more and more investment managers use computerized trading algorithms.  These algorithms can spot a pricing discrepancy in less than a second and place trades to take advantage of the pricing discrepancy just as quickly.

Critics often claim that ETFs will reduce the liquidity of the stocks they hold.  The naysayers of ETFs like to paint the picture that the assets go into ETFs and just sit there, effectively reducing the freely traded shares of the companies that the ETF holds.  They claim that the ETFs will make the stock markets less efficient and less liquid.  But it certainly doesn’t look that way.

The largest ETF in the world, the SPDR S&P500 ETF Trust (SPY) had almost $200 billion in assets at its last year-end.  What was really stood out in SPYs financial statements was the turnover of those assets was more than 4x that amount!  The largest ETF in Canada, iShares S&P/TSX 60 Index ETF (XIU), had $12.2 billion in assets at its last year end and its turnover was double that.

If ETFs owned all freely traded shares (that is, those that are not held by insiders and subject to trading restrictions) that that would be a problem.  But ETFs make up such a small part of the stock markets that most of the criticisms being levied at ETFs hold no weight.  ETFs are far from the weapons of mass destruction that their detractors would have you believe.

 

May Economic Indicator Recap

Below are the current readings on the major economic indicators: central bank interest rates, inflation, GDP and unemployment.

Below are the current readings on a few other often followed economic indicators: retail sales and housing market metrics.

A Closer Look at the Canadian Economy

Canada’s unemployment rate declined to 6.5% in April; 34,300 part time jobs were added but 31,200 full time jobs were lost.  The decline in the unemployment rate was mostly due to the labour force participation rate declining to 65.6%.

Housing prices across Canada rose +1.2% in April.  Toronto (+2.6%), Hamilton (+2.1%), Victoria (+1.5%), and Halifax (+1.4%) all provided the gains greater than the national average.  The number of new housing starts declined -15.1% in April to 214,100, while building permits declined -5.8% in March.

The inflation rate was +0.4% in April, or +1.6% on an annual basis.  Core inflation which excludes more variable items such as gasoline, natural gas, fruit & vegetables and mortgage interest was +1.1% for the last year, the lowest level since November 2013.  Retail sales rose +0.7% in March.  The increase was attributed to higher new car sales.  Compared to a year ago, retail sales were up +6.9%.

Canada’s GDP rose 0.5% in March on a rebound in manufacturing activity.  The Bank of Canada left the benchmark interest rate unchanged at their May 24th meeting.  The next meeting is scheduled for July 12th.

 

*Sources: MSCI, FTSE, Morningstar Direct, Trading Economics


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Isaac Schweigert

Isaac Schweigert

Isaac is a CFA charterholder and is Portfolio Manager and Chief Compliance Officer at ModernAdvisor. He has over 11 years of investment industry experience, including asset allocation, portfolio management, due diligence, compliance and reporting.