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ETFs and the Market Cycle Thumbnail

ETFs and the Market Cycle

Submitted by Sara Worley & Brendan Donahue

Investment Advisors, Manulife Wealth Inc.

        Many people know that some equity sectors perform better than others during different phases of a market cycle, but what about the investment approach? Should investment products change along with the markets? 

In Steadily Rising Markets

        During the recovery and expansion phase of the market cycle, passive investments like index mutual funds and Exchange-Traded Funds (ETFs) generally perform better than actively managed mutual funds. This is because stocks are cheaper than usual during times of recovery, and passive investments are cheaper than active investments.  

        Consider the economic events of 2008-2009: a worldwide liquidity crisis prompting the TSX to fall 50 per cent from its 2008 high. Over the next 10 years, the stock markets enjoyed a long recovery and expansion phase where, aside from a few short periods, stock valuations steadily rose. The markets were euphoric; they had a long way to go up and investors benefited tremendously. Using active mutual funds during this period worked well, but owning ETFs was more efficient.  

In Normal or Volatile Markets

        During the contraction and recession stages of the market cycle, active management tends to outperform passive. This is because ETFs are undiscerning: they own everything, regardless of what’s going on in the markets. In essence, the feature that most helps ETFs during hot markets works against them the rest of the time.  

        On the other hand, active management profits from the two biggest ways that money is made in stock markets: volatility and mispricing. An active manager selects stocks based on factors like current market conditions, company analysis, asset pricing and forecasting. This kind of assessment is essential to making money and minimizing losses during normal or uncertain markets. 

The Misconception

        Some people think that ETFs are a way to “hack” the investment world: they’re cheaper and more diversified than active strategies and therefore, will always produce better returns. This is a misconception. ETFs are designed to mirror stock market indexes, not beat them. And in reality, they always lag behind their index on an after-fee basis. 

        Further, overuse of ETFs can cause extra volatility in the stock markets. How? During steadily rising markets, lots of money flows into stocks and the bigger the rally is, the more money flows into everything. This means poor quality stocks do much better than they should due to invested money needing a home. ETFs amplify this by adding more or less equal amounts of money to everything. This means poor quality stocks get more than their fair share of investment dollars and rise in value further than they would if everyone was a discerning investor. This disproportionally rewards poor stocks and positions investors for losses when the chickens come home to roost. As Warren Buffett famously said, “You find out who is swimming naked when the tide goes out.” 

        When the dust settles, active money tends to flow back into good assets, and usually at a discounted price. Passive investments will simply continue to own the index. As long as a stock remains part of an index, the ETF will buy it, and the investor will have to endure its ups and downs.

Final thoughts

        In many aspects in life, human beings have a herd mentality. Some people don’t want to step away from the pack in case it’s in the wrong direction. ETFs are a herding investment, and their returns are generally in the middle of the pack.

        ETFs are fine for investors who want to trail the markets, and work well during times of recovery and expansion. They are also good for broad based market exposure over long periods. But ETFs are only as good as the markets. During times of contraction and recession, like what we are experiencing today, investors need to ask themselves, do I want to copy the market? Or do I want to step away from the herd?