This content is from: Portfolio

Passive, But Out of Control

The market is unprepared to cope with how large the ETF industry has become, says Highland Capital’s chief investment officer.

  • Alicia McElhaney

When Mark Okada, co-founder and CIO at Highland Capital Management, saw news that index fund giant Vanguard Group’s inflows were larger than all other asset managers’ combined for the first quarter of 2016, he said he was worried.

In December of last year alone, according to Morningstar, passively managed funds took in a record $50.8 billion.

The hulking size of ETFs — and what happens when ETF buyers become sellers — is a question keeping Okada up at night, the money manager told reporters at a May 25 lunch in New York City. “They’ve gotten so big so fast,” he said by phone Tuesday. “I don’t know if the market knows how to risk manage ETFs in the opposite direction.”

ETFs could play a big role in the next recession or financial crisis, according to Okada, and passive-fund managers need to be prepared to manage risk in a “different type of market structure.”

What if, he offered as an example, U.S. President Donald Trump decided to go to war with North Korea? “We’d probably go into a risk-off period,” Okada said. “We’ve never been able to test this in a market so saturated by ETFs.”

But ETFs have been around for a long time and managed to weather the tech bubble bursting and the 2008 financial crisis, argued Will Rhind, the founder of commodities ETF Granite Shares. “Whenever there’s any new technology or wave of investing, there are always naysayers who want to say the sky is falling,”

Still, though, there were far fewer ETFs in the equities market then than there are now. More indexes of equities now exist than actual US-listed stocks — a statistic reported earlier this month by Bloomberg that has become a favorite among asset managers and industry pundits.

Okada finds the situation concerning, while acknowledging that he doesn’t want to “call the market” on competing styles of money management. “I wouldn’t recommend someone being exclusively passive,” Okada added. “I just worry that some people just put everything into the passive basket. They won’t be able to pick up the pieces in different market situation.”

But Okada and others need not worry, according to Kevin Quigg, chief strategist at customer satisfaction-based ETF ACSI Funds. Exchange-traded funds own 6.3 percent of an average listed company’s shares, Quigg pointed out in a phone interview, citing statistics from Toroso Investments. “Relative to the larger investing industry, ETFs are a small component,” Quigg said.

One could voice the same concerns about mutual funds, he added.