Industry Updates

ETF money boosts US markets - can it last?

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The FT reported at the weekend that $391 billion went into ETFs worldwide this year. That's already ahead of the equivalent for the whole of 2016 - $390 billion.

The news comes after a bit of stock market wobble last week amid increasing worries that the 8-year bull market may be coming to an end. The worries are particularly strong in the US, where ETFs have been most popular.

Concerns about the US market are completely understandable. The S&P 500 now trades on a price/earnings ratio of 24, well above average, but not the highest ever. It's a similar story with the cyclically adjusted price/earnings ratio (CAPE) which has reached 29, higher than average but not an all-time peak. (The CAPE ratio compares share prices to average earnings over the last ten years. Its adherents claim it gives a more accurate picture of a company's valuation.)

And plenty of US companies look overvalued to many observers. Amazon, for example, is trading on a price/earnings ratio of 160 while Facebook is on a p/e of 38. Both companies need to keep growing at some lick to justify those valuations.

Last week the S&P 500 fell by almost 3% which is a sizeable fall but on its own it doesn't signal a major correction in the markets. Bigger falls could be triggered by further tension with North Korea or if it becomes clear that President Trump definitely won't be able to push through a big tax cut at some point in the next year.

So what have ETFs got to do with this all?

Well, the point is that all this extra money going into ETFs of course goes into markets, and this big flow of money into ETFs is probably one of the reasons why the post-financial crisis boom has continued for so long. And, of course, the problem with the vast majority of ETFs is that they're passive. Now passive investing in many respects is an extremely good idea, but one downside is that passive funds end up buying more shares in companies that are expensive than companies which are cheap. That's because the expensive companies often have a bigger share of the underlying index.

As ETFs continue to buy shares that have already risen huge amounts in recent years, you could argue that the rise of ETFs over the last decade has helped to sustain this bull run for longer than would otherwise have been the case. If share prices do fall significantly over the next months - and that's a big if - then ETF critics would argue that ETFs won't be the best place to be. An ETF's investments in already expensive stocks will be caned.

So what should investors do?

If you think you might need the money at some point in the next couple of years, then you should think about selling at least some of your shares. There's a decent chance that share prices will be lower in two year's time than they are now. But if you're more of a long-term investor, then it's probably best to sit tight. Timing the market is very tough, and history suggests that share prices in ten years' time will probably be higher than they are now. That's not definite but your chances are good.

And if you want to play the long-term game, ETFs are an attractive option. In spite of the defect that we've just looked at, the low charges and the simplicity of most ETFs wins out in the end.


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