ETFs inflate corporate valuations: investment strategist

Michael Green, chief investment strategist at Simplify Asset Management, joins BNN Bloomberg to discuss the risk of passive investment to the markets.

Canadian investors are putting money into exchange-traded funds (ETFs) creating a systemic risk for traders, an investment strategist says.

Michael Green, chief investment strategist at Simplify Asset Management says passive investments disproportionately boost large volatile stocks.

“Everything in the index is in proportion to its market capitalization,” says Green. “That ends up pushing the securities that are the largest and most volatile components of the index up disproportionately. That, in turn, means the next dollar in which comes the very next day, or, in the case of ETFs, sometimes the next minute, will actually push them even further in that same direction.”

He says the constant inflow of funds to ETFs has distorted markets pushing company valuations above their true worth.

Rather than pricing stocks based on how a company performs, passive investments bunch securities together increasing the correlation between stocks and their index, he says. That means a company’s price is driven by the money flowing in rather than by it’s fundamentals.

Green says investors have benefited from a reduction of fees independent of a company’s market cap, but “liquidity does not scale with market capitalization and so bias has been created in the market as we have grown passive.”

“This has created a remarkable disconnect between the economic underpinnings and the actual performance of the securities that creates a systemic risk, one that can’t really easily be diversified or hedged,” says Green.

He says passive investments and correlated stock behaviour lower future returns.

“Unfortunately, we have very clear evidence that this is actually what is happening in markets, and it’s creating many of the social ills that we experience as governments have based investments for retirement purposes into passive vehicles particularly those that are focused on large cap stocks,” says Green.