For the first time, the value of transactions in exchange-traded funds tracking the Standard & Poor’s 500 Index (SPX) is poised to exceed the turnover for all the stocks in the benchmark gauge of American equity.
Dollar volume in the SPDR S&P 500 ETF Trust, the iShares S&P 500 Fund and the Vanguard S&P 500 ETF reached a 12-month average of $28 billion a day last month, 98 percent of the trading in the index’s companies, which include Apple Inc. (AAPL) and Exxon Mobil Corp., data compiled by Bloomberg and Goldman Sachs Group Inc. (GS) show. Investors have flocked to the securities that mimic benchmark returns after the financial crisis increased swings and correlations between assets.
For bears, the increase in ETFs shows investors are giving up on picking stocks and searching for value in favor of automated, day-trading, computer-driven strategies that undermine the integrity of the stock market when they fail. Bulls say demand for the products, which didn’t exist two decades ago, shows that individuals and institutions are still keen to own equities. They’re just fed up with the fees managers charge without delivering adequate returns.
“ETFs not only have allowed investors to get in on this risk-on, risk-off environment, but they have allowed many an immediate exposure to the market without having to identify the right stocks,” said Mike Lenhoff, chief strategist at Brewin Dolphin Securities Ltd. in London, in an Aug. 3 phone interview.
ETFs have been under scrutiny by regulators trying to gauge whether they are contributing to the surge in high-frequency and algorithmic trading. A malfunction in the computer systems run by Knight Capital Group Inc. (KCG) last week triggered sudden price swings of 10 percent or more in dozens of U.S. stocks.
Demand for products that track equity gauges is increasing as flows to mutual funds that buy individual stocks decline. Assets under management for global ETFs topped $1.46 trillion this year, up from $1.30 trillion in 2011, Deutsche Bank AG data show. North American equity exchange-traded products have lured $29.3 billion so far this year, according to BlackRock Inc. (BLK), following total inflows of $103 billion in the last three years.
By contrast, U.S. funds that invest in American shares have had net outflows of $18 billion in 2012, on top of $257 billion taken out from 2008 to 2011, according to EPFR Global in Cambridge, Massachusetts. Developed-market equity mutual funds have lost $52 billion in 2012, the data show, after redemptions of $491 billion in the preceding four years.
Only 13 percent of actively managed funds were beating their benchmark index by at least 2 1/2 percentage points this year as of July 23. The proportion was the lowest since at least the mid-1990s, according to data compiled by JPMorgan Chase & Co. and Bloomberg. Of funds run by stock pickers, 32 percent were at least 2 1/2 points behind their benchmarks, the data show, matching the highest figure since 2003.
Active managers charge higher fees. Equity funds in the U.S. cost owners 1.44 percent of assets annually, on average, according to Morningstar Inc. Comparable ETFs charge 0.5 percent, according to the fund research firm.
“There’s been a big shift, with a lot of large investors moving away from active investment to passive,” said Guy Fraser-Sampson, a senior fellow at Cass Business School in London who wrote the books “The Mess We Are In” and “Multi- Asset Class Investment Strategy.” “There is a growing recognition now that it is very difficult for active equity investors to consistently outperform. A lot of long-only managers do not justify their fees.”
The S&P 500 last week rose 0.4 percent to 1,390.99, boosting its advance for 2012 to 11 percent. A report on Aug. 3 showed payrolls in the U.S. climbed by 163,000 in July, exceeding the median forecast of 100,000 in a survey of 84 economists by Bloomberg. Futures on the S&P 500 advanced 0.2 percent at 6:12 a.m. in New York today.
Instead of trying to beat the market, or producing so- called alpha, by picking individual stocks, investors are trying strategies that involve timing moves, according to Christian Mueller-Glissmann, London-based equity strategist at Goldman Sachs. Higher volatility has drawn investors to index trackers and away from riskier single-stock bets, a team of analysts at Bank of America Corp. led by Jon Maier wrote in a note published June 27.
The S&P 500 has moved up or down 1.15 percent a day since the collapse of Lehman Brothers Holdings Inc. in September 2008, according to Bloomberg data, compared with an 80-year average of 0.75 percent before then. The Chicago Board Options Exchange Volatility Index, or VIX (VIX), has averaged 26.6 since the start of 2008, compared with 14.7 in the previous four years.
“With macro risk and anxiety taking over during an economic downturn, investors are looking at equities more as an asset class rather than the individual companies,” Mueller- Glissmann said in an interview. “Investors have a better chance to generate alpha by focusing on trading and picking equity indices rather than stockpicking.”
The SPDR S&P 500 ETF is managed by Boston-based State Street Corp. (STT) and the iShares fund is controlled by BlackRock Inc. in New York, while Vanguard Group Inc., based in Valley Forge, Pennsylvania, oversees the Vanguard S&P 500 ETF.
High volume in the S&P 500 funds is more representative of day trades than long-term ownership, said Christos Costandinides, European head of ETF research and strategy at Deutsche Bank. The turnover has coincided with an increase in so-called high-frequency trading. The practice, known as HFT, has accounted for about 53 percent of trading this year, up from 26 percent in 2006, according to Tabb Group LLC, a New York- based financial industry research firm.
ETFs suit high-frequency traders as they allow them to jump in and out of the market more quickly than buying a basket of shares in individual companies, said London-based Costandinides.
“A lot of the S&P 500 ETF turnover can be attributed to active trading strategies,” Costandinides said in an interview. “Portfolio trading is becoming much more prevalent than single-stock trading. That is one of the trends that have transpired over the past two years.”
High-frequency trading is a technique that relies on the rapid and automated placement of orders, many of which are immediately updated or canceled, as part of strategies such as market making and statistical arbitrage and tactics based on momentum. Getco LLC and Citadel LLC, both based in Chicago, and New York-based Virtu Financial LLC are among the biggest automated-trading firms.
The increased use of index-derivatives products such as ETFs has fueled a debate on whether they are responsible for increased correlation between markets, or whether prices that move more in lockstep push investors into ETFs.
Stock prices can be influenced by the trading of ETFs, Robert D. Boroujerdi, a Goldman Sachs analyst and three colleagues wrote in a paper in January. Among S&P 500 companies, Houston-based FMC Technologies Inc., an offshore-drilling technology firm, was the most affected, with an estimated 23 percent of volume driven by ETF trades.
Writing in a National Bureau of Economic Research paper in September 2010, New York University Professor Jeffrey Wurgler reviewed research that suggested that “index-linked investing is distorting stock prices and risk-return tradeoffs.” The paper later added that “the evidence is that stock prices are increasingly a function not just of fundamentals but also of the happenstance of index membership.”
As macroeconomic stories have come to overshadow news from individual companies, investors have found in ETFs a cheaper and quicker way to get in and out of the entire equities market, said Joel Dickson, investment strategist at Vanguard.
“What we have seen is more trading in basket-type securities, where you are trying to adjust asset allocations and not trading individual securities as such,” Malvern, Pennsylvania-based Dickson, whose firm oversees $200 billion in ETFs, said in a phone interview on July 27. “You are getting the diversification and risk exposure to the asset without the additional volatility of the securities.”
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