(Not urgent, just important.)
I want to point out a problem that I foresee, potentially on the scale of the technology bubble in 2001 and the housing bubble in 2007. I think we’re going to have an “inverse ETF bubble.” It’s not that I anticipate ETF prices being driven ridiculously high, but rather that when the next stock market correction arrives, I believe ETF prices will suffer far more than the broader stock market.
Individual investors (as opposed to institutional investors) own 293 million shares of the largest U.S. equity ETF, SPDR S&P 500 ETF (SPY). They also own 214 million shares of iShares Core S&P 500 ETF (IVV), 448 million shares of Vanguard Total Stock Market ETF (VTI), and 171 million shares of Vanguard S&P 500 ETF (VOO). Those are just the biggest four, ranked by total assets. In fact, there are over 1,000 U.S. equity ETFs for investors to choose from.
This proliferance of ETFs did not exist during the last major U.S. stock market downturn. And that means most individual investors have no idea what to expect from their ETFs when the next stock market downturn arrives, because they’ve never seen it happen.
Let me make this abundantly clear: I am not predicting the timing of the next stock market downturn. What I am predicting is what will happen to ETF share prices when the inevitable stock market downturn comes along, and I don’t think it will be a pretty sight. Many individual investors are going to walk away bruised, and withdraw from the stock market again, just like they did after all the previous major stock market corrections and crashes. That’s because individual investors, as a group, are too fearful to “buy low.” (Yes, of course there are brave, experienced investors among them, but I’m talking about the majority, as evidenced by classic investor psychology.)
Here’s the problem: Unlike common stock share prices, ETF share prices can’t rebound if individual investors are not buying them!
I just said a mouthful, didn’t I? I’ll explain, by making a comparison between mutual funds and exchange-traded funds (ETFs).
Most investors know that mutual funds trade at net asset value (NAV). The share price always represents the exact pricing of the basket of stocks held within the mutual fund. Of course a mutual fund share price will fall during a stock market downturn. But then institutional investors begin buying bargains, and they drive the share prices back up. Individual investors, on the other hand, mostly sit on the sidelines, too scared to buy low. They watch with skepticism as the stock market rebounds, still focused on the downturn that has become history. In this scenario, stock prices rebound because institutional investors buy low, and mutual fund prices rebound because stock prices rebound. Are we clear on that? Institutional investors drive stock market recoveries.
ETFs are a different animal from mutual funds. Even though an S&P 500 index ETF represents the same exact stocks that you find in an S&P 500 index mutual fund, the pricing of shares is very different. An ETF has an NAV, just like a mutual fund. But an ETF doesn’t trade at its NAV! ETFs trade based on supply and demand. When people are buying them, the share prices rise, and when people are selling them, the share prices fall. Stock market emotion, such as fear or exuberance, can easily affect the amount of buying and selling, thereby pushing ETF share prices above or below NAV.
Just because you have usually seen ETFs trade very close to NAV in the past, does not mean that they will trade close to NAV during a stock market correction. Here’s why: When investors get scared, they sell their shares.
You might look at an ETF NAV at 12.60 and its share price at 12.40 and think, “Oh, it’s selling at a small discount to NAV. No problem.” But if the share price was recently 15.20, the investor is seeing a loss of 17% in their invested capital. Even if the stock market stabilizes, and the NAV drops no further than 12.60, at this point panic has set in among investors. More of them sell the ETF, driving the price to 12.15, for example. Additional shareholders see that happen, and they add to the panic, thinking “Why is my share price falling when the rest of the market has stabilized?” Another round of panicked selling occurs. Now the price is 11.72, yet the NAV hasn’t changed much from 12.60 because the broader stock market stopped falling a while ago. The more people panic and sell, the farther they will drive the share price down, thus triggering more and more panicked selling. In the meantime, people who owned the S&P 500 mutual funds saw their share prices stabilize when the broader market stabilized!
In that scenario, ETF share prices will not rebound until people start buying them again. Most experienced investors know that the average investor waits a very long time before reentering the stock market after a stock market correction. And unfortunately, that means there will be very little buying activity among ETF shares. The buying activity is the lynchpin of the ETF rebound.
I sure hope this makes sense, because it’s an incredibly important concept. ETFs trade based on supply and demand, while mutual funds trade based on NAV. When you own an ETF during stock market downturns, you have a lot more share price risk than does an investor who owns mutual funds that hold the same exact stocks.
I’m not trying to scare you. I’m trying to explain a stock market phenomenon that could easily happen. Please contemplate the true risk associated with ETFs, and adjust your portfolios accordingly.