With 1,400 exchange-traded funds (ETFs) created in recent years, and several billion under management, is this ETF phenomenon creating artificial pressure on demand for shares, leading people to believe that part of the good performance of the indices is artificial?
Claude Rheaume
Passive investing in exchange-traded funds (ETFs) can reduce investors’ focus on fundamentals and contribute to inflated price-earnings ratios, says Guillaume Arseneau, associate analyst at Canaccord Genuity Capital Markets.
Generally speaking, he said, studies on the subject find a positive statistical link between the inclusion of securities in an ETF and stock valuations.
“We are talking about an order of magnitude of 1 to 2% on the price-earnings ratio (P/E) compared to the stocks that are not included. We can only speculate on the causes, because a statistical link does not necessarily represent a cause-and-effect link,” he says.
While ETFs are primarily focused on large-cap stocks, he adds that the concentration of capital flows into these investment vehicles can increase market price-earnings ratios given the relative weight of these stocks in indices and ETFs.
Investment themes
This impact can also be materialized by investment themes. To this end, he cites for example the growing popularity of a particular sector, for a certain time. “In other words, all boats surf the wave when it passes,” says Guillaume Arseneau.
He also adds that it is necessary to differentiate between the liquidity of an ETF on the market and the liquidity of the underlying securities.
“Liquidity can dry up quickly when the market becomes more turbulent or uncertain. This can amplify price movements and price-earnings ratios during a market correction.”
Following this logic, ETFs can also reduce the market’s price-earnings ratio under certain conditions.
Guillaume Arseneau argues that analyzing stock performance and therefore the possible effect of ETFs on the market is difficult because performance and returns reflect not only expectations about future earnings, but also the level and direction of interest rates and capital flows into or out of the market, to name a few factors.
“It is generally accepted that ETFs allow investors to purchase a potentially more diversified portfolio of stocks at a lower cost than if they were to purchase individual stocks.”
Moreover, Guillaume Arseneau points out that the ease of buying an ETF for a small investor can have the effect of attracting financial capital that would never have entered the stock market without this innovation.
“In other words, more dollars in the market for the same amount of shares outstanding, all else being equal, would translate into higher price-earnings.”
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