The stock market collapse has blown a giant hole in mindless ETF investing (SPX)

• Exchange-traded funds are useless in a downward market, according to David A. Rosenberg of Gluskin Sheff.
• In fact, they have contributed to the mindless runup that is now unwinding.
• “The masses don’t want to pay fees for making critical decisions on their behalf. This may work in a market that is a straight-line up but sure doesn’t work when the going gets tough and the bull market gets punctuated with volatility and corrective behavior,” he told clients.
• “Over 50% of the rally in the Dow in 2017 came down to just five stocks and over 80% of the advance was centered in ten names. That concentrated character was exactly the same in the opening weeks of the year up to the all-time highs. So many ETF investors believe they are in diversified safe strategies when the exact opposite has been the case,” he argues

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If your retirement savings are invested in an exchange-traded index fund (ETF), you’re probably hurting from last week’s stock market collapse. The S&P 500 Index has fallen more than 10% from its high in the last few weeks.

ETFs are designed to track indexes like the S&P 500, so that you get the same rate of return as if you had bought the market as a whole. In most years, that works out better than giving your money to an active investment manager — because most managers, notoriously, underperform the market as a whole. Investors also like them because they offer a diversified portfolio: You’re buying every stock in the index.

ETFs have become really popular in the last 10 years. Today, ETF indexes represent 25% to 30% of trading volume on any given day, according to the Financial Times.

The growth in exchange-traded funds and other exchange traded products, by assets under management, annually.Deutsche Bank

The fear is that passive investment — when retirement savers let their 401(k)’s and private pension plans pour a slice of their salaries into ETFs, month after month — has driven up the value of the entire stock market through thoughtless buying.

Last week’s massacre exposes another problem: ETFs have never really been through a down market at this scale. Cash inflows into ETFs are now worth a total of $1.4 trillion.

ETF holders generally only have two choices in a bear market, and both of them are bad:

• Continue to hold the funds, and take the loss in value.
• Or sell the funds, take the loss in value, and accelerate the downward price momentum.

David A. Rosenberg, the chief economist and strategist at Canadian wealth management firm Gluskin Sheff is pretty angry about this. In a note to clients last week, he argued that the crash exposes a huge flaw in ETFs:

“What has been exposed is the pitfalls of passive ETF investing. This has triggered massive unconstrained and undisciplined buying activity because the masses don’t want to pay fees for making critical decisions on their behalf. This may work in a market that is a straight-line up but sure doesn’t work when the going gets tough and the bull market gets punctuated with volatility and corrective behavior.”

“These investors go and buy a basket that they believe to be diversified but that is far from the case. Remember how concentrated this market has been in recent times — over 50% of the rally in the Dow in 2017 came down to just five stocks and over 80% of the advance was centered in ten names.

“That concentrated character was exactly the same in the opening weeks of the year up to the all-time highs. So many ETF investors believe they are in diversified safe strategies when the exact opposite has been the case. Time for a rethink when they see a couple of stocks in the basket they invested in end up exerting such an outsized negative influence on what they own in aggregate.”

Gluskin Sheff is an active manager, so Rosenberg is biased. He thinks investors should “rely on brains rather than buttons, which, by the way, is our edge.”

Nonetheless, he says: “ETF investors who get their next statement, may be shocked that the market has not continued to move ever higher. They may want to start thinking about that as we enter this entirely new bull market in two-sided trading and heightened volatility.”

This is an opinion column. The thoughts expressed are those of the author.