We have been concerned about the rapid rise in popularity of exchange-traded funds (ETFs) for a long time. Over ten years ago, at a conference on the topic of ETFs, we were given a book that explained how they worked and how to use them in strategies; the book was almost 700 pages long. It struck us that any investment vehicle that took 688 pages to explain was problematic.
This past Wednesday, July 15, there was an extremely interesting conversation at the "Delivering Alpha" conference in New York City, hosted by CNBC and Institutional Investor, in which investor Carl Icahn raised some extremely important points about ETFs which we believe every investor should consider very carefully.
During a panel which was apparently going to be about "investor activism," Carl Icahn made some very hard-hitting remarks about dangers posed by ETFs (exchange-traded funds) and most particularly the danger that ETFs may be seen by many investors as offering a degree of safety and a degree of liquidity which they do not possess.
This subject is one of tremendous importance because ETFs have grown to be an enormous segment of the global and US investment markets in both stocks and bonds and also in commodities. According to the Investment Company Institute, there are about $2.7 trillion invested in ETFs world-wide, about $2.0 trillion of which are in ETFs based in the US.
Therefore, when Carl Icahn (whose professional investment career started in the year 1961, and whose company Icahn Enterprises manages over $24.5 billion in assets) says that he believes ETFs are perceived as having a level of safety and a level of liquidity which they do not possess, we believe investors should pay very close attention to what he is saying.
While the discussion between Mr. Icahn and BlackRock CEO Larry Fink included a debate about whether higher interest rates are going to negatively affect high yield bond prices, that was really a sidelight to what we feel is the more-important discussion about the perception that ETFs are safe, liquid investments that are inexpensive and “easy” for the average investor to “own."
It is this last point that we feel is the most important, and wasn’t directly addressed by Mr. Icahn -- although he did make reference to the fact that in order to discuss what's going on inside an ETF he "could get into some arcane stuff" -- is that the “investor” is really not “owning” anything when “investing” in ETFs. At its core, the ETF is just another form of derivative. If there is anything the 688-page book taught us it is that it is not the average investor, but rather the supporting banks that can “ask for their shares” at any time from the funds.
As advocates of true price discovery, it occurs to us that the farther away the so-called “investor” is from the ownership of the investments they think they are making, the more potential pitfalls there are when times get tough. This is why an investor with the stature of Carl Icahn making points about the pitfalls of ETFs is worth noting.
It is this last point that we feel is the most important, and wasn’t directly addressed by Mr. Icahn -- although he did make reference to the fact that in order to discuss what's going on inside an ETF he "could get into some arcane stuff" -- is that the “investor” is really not “owning” anything when “investing” in ETFs. At its core, the ETF is just another form of derivative. If there is anything the 688-page book taught us it is that it is not the average investor, but rather the supporting banks that can “ask for their shares” at any time from the funds.
As advocates of true price discovery, it occurs to us that the farther away the so-called “investor” is from the ownership of the investments they think they are making, the more potential pitfalls there are when times get tough. This is why an investor with the stature of Carl Icahn making points about the pitfalls of ETFs is worth noting.
You're welcome to skip down and watch the videos at any time -- here, in a list format, are some of our thoughts and comments about this very important subject:
- We have in fact written about our discomfort with the ETF trend in the past. See for instance this blog post entitled "The ETF industry and their promise of easily adding alpha for all," from back in 2009, which we believe is just as relevant today as it was when we wrote it six years ago.
- At Taylor Frigon Capital Management, we invest in companies directly, by owning individual securities issued by those companies. This means that we are obviously biased in this argument, because we compete against investment advisory services using ETFs. But we could have chosen to use ETFs if we wanted, and after significant analysis decided that, at best, the underlying complexity was problematic, and at worst, the ETF is a potential time bomb that may have systemic implications if they continue to grow without adequate understanding on the part of investors as to exactly how they work.
- While we don’t likely agree with Carl Icahn on everything, we do invest in individual companies on behalf of our clients, including some companies in which Mr. Icahn, through Icahn Enterprises, is a very large shareholder, such as Apple (AAPL) and CVR Energy, Inc. (CVI).*
- We also believe in investing in those companies directly for both our clients and ourselves.
- We believe that Carl Icahn is doing the investment community a great service by forcefully calling attention to what he believes is a potential problem: the fact that investors may be mistaken in attributing to ETFs a level of safety and liquidity which may be unwarranted (specifically with regards to ETFs which own an inherently illiquid and sometimes risky investment: high-yield bonds). Note that Carl Icahn says in some of the video segments below that he feels some remorse for not being more outspoken about concerns he had prior to 2007 and 2008 about a different category of pooled investment vehicles, but that he wants to say now very clearly that he perceives some potential problems of a very serious nature (while not specifically predicting any sort of immediate crisis).
- Although Carl Icahn did not specifically say it -- and this post is not intended to imply that he did -- we believe that some of the same criticisms that he applies to high-yield bond investing through ETFs can be applied to many other types of investing through ETFs. Specifically: just as Mr. Icahn is saying that investors in high-yield bond ETFs feel a certain "distance" from the underlying security (in this case, high-yield bonds) and don't feel that they need to perform the kind of individual due diligence on each individual security connected to that ETF, and just as investors in those high-yield bond ETFs feel that the ETF makes high-yield bond investing more liquid and more safe than individual high-yield bond investing (but the reality may in fact be quite the opposite), we believe that investors in almost any kind of ETF including those which invest in stocks end up distancing themselves from attention to the specific business factors of the business in which they are investing. And we believe that this can be a dangerous pattern, no matter what the underlying investment happens to be.
- We also find it interesting that some of Mr. Fink's comments in the video can be seen as indirectly or perhaps unintentionally providing support for the point we just made. For instance, in the very first clip beginning about 10 or 15 seconds from the start of the clip (before Mr. Icahn even begins his hard-hitting criticism of ETFs), he says (as a function of how much his investment management firm manages in index funds):
So, we have to own companies that are poorly-run, and companies that are well-run. We own all the companies [expansive hand gesture]. Unlike active investors -- and a lot of our money . . . we manage active, too -- our investors can't sell those stocks if they hate the company. We're only . . . we have to own the stock whether we like it or not, and the . . . so, we have a much greater responsibility in working with companies, and hopefully over time working with the companies to build the proper returns that we expect from them. And then sometimes, we will even agitate, but we will do it privately and quietly. [Punctuation in the above quotation uses ellipses to indicate a pause or a change in direction of the sentence, and not to indicate words omitted from the quotation: no words were omitted from the quotation in the clip, as we hear the audio].
- We find that admission to be a pretty good description of what we believe is the core problem with the whole category of index and ETF investing. The premise on which these forms of investment are built is inherently opposed to the kind of scrutiny of the underlying investment (whether it be a stock issued by a company, or a high-yield bond) that we believe is the very heart of responsible investment.
There is much more that could be said about some of the many important related subjects raised during this exchange between Carl Icahn and Larry Fink. However, we believe that this one central issue -- about the perceived safety and liquidity in an investment vehicle which makes up an enormous percentage of the global investment landscape -- is the issue that investors should take the time to consider very, very carefully.
Towards the beginning of his own remarks, at the start of the second video segment, Carl Icahn says: "And I really mean this -- I'll just say what I mean. I'm too old not to say what I mean, and I don't hold back."
No matter what your opinion of Carl Icahn or of what he says after that, you have to respect him for making that statement, and then for very bluntly "saying what he means" because it is what he believes investors need to hear, and what investors need to know.
And when someone with as much market experience and success as Carl Icahn has, sits down and very plainly tells you that he is going to freely say what he means, we think investors should pay attention. And we applaud him for doing it.
And when someone with as much market experience and success as Carl Icahn has, sits down and very plainly tells you that he is going to freely say what he means, we think investors should pay attention. And we applaud him for doing it.
video one http://video.cnbc.com/gallery/?video=3000397684
video two http://video.cnbc.com/gallery/?video=3000397844
video three http://video.cnbc.com/gallery/?video=3000397885
video four http://video.cnbc.com/gallery/?video=3000397886
video five http://video.cnbc.com/gallery/?video=3000397882
video six http://video.cnbc.com/gallery/?video=3000397887
* At the time of publication, the principals of Taylor Frigon Capital Management did not own securities issued by BlackRock (BLK). At the time of publication, the principals of Taylor Frigon Capital Management did own securities issued by Apple (AAPL) and by CVR Energy (CVI).
