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Investor predilections, fixations and manias never come out of nowhere. They're always based on kernels of truth or behavior conditioned by years of real-world experience.
So it is that the ascendance of exchange-traded funds as the fastest-growing investment product is rooted in the true-life happenings of the last several years. Namely, this trend reflects the way the market has withheld rewards for individual stock-picking, with stocks instead moving in lock step up or down. This partly reflects the dominance of macro, rather than company-specific factors, in driving returns.
Standard & Poor's last week reported that over the prior three years, nearly 58% of large-cap stock funds trailed the S&P 500, and among actively managed products, 84% of mid-cap funds and 70% of small-caps were beaten by their benchmarks.
Thus, investors have been conditioned to view indexes—especially when easily captured in a highly liquid ETF—as a way to gain exposure to market segments without sacrificing returns. The effect is self-reinforcing, as ETF buying and selling pushes individual stocks around, rather than vice versa.
Speaking of factors, the dominance of the "macro trade," in which a handful of global economic forces set the tone for the markets, is handily reflected in a new series of FactorShares ETFs, which track specific macro relationships between major asset classes. The poster child for this market dynamic is the new FactorShares 2X Oil Bull/S&P 500 Bear fund (ticker: FOL), which owns crude oil and is short the S&P 500 against it, delivering twice the return differential between the two. This product both institutionalizes the stance that oil and stocks are inversely correlated, and leverages that view. So, the (mostly hypothetical) buy-and-hold owner of such a fund needs to be right about what the underlying markets are likely to do, and right that the relationship between them will remain consistent.
It's a fund made for a market grown twitchy over Mideast tensions. Traders who three months ago couldn't find Tunisia or Libya if you handed them a globe are suddenly experts on the Suez Canal and the "obvious" inverse linkage between Brent crude prices and the value of such S&P 500 stocks as Microsoft (MSFT) and Johnson & Johnson (JNJ).
More broadly, a mini-generation of professional and at-home traders alike are addicted to macro data points as drivers of the "risk on/risk off" trade. Check Spanish government-bond credit-default-swap prices, the forward crude-oil curve and the futures on the CBOE's Market Volatility Index (VIX), goes the logic, and you can "win the day" via ETFs.
It's enough to get contrarians' antennae twitching. For a while before the latest Mideast eruptions, correlations among stocks had begun to recede, the market rewarding and punishing individual names based on idiosyncratic news. This seemed to confuse traders grown accustomed to the post-2007 market, but in reality it was simply a return to a rotational, winners-versus-losers winnowing of years gone by.
As Steven Sears details in his Striking Price column, correlations have again picked up, which elevates volatility and makes active investors' jobs much tougher. So we're all macro handicappers again—for the moment.
Who knows how long this relapse will last, though the corporate-bond markets are unmoved by the latest geopolitical rumblings, suggesting this is the long-awaited correction in stocks if it rolls on, rather than the start of another macro shock. And for all the commemorative "two-year bull-market anniversary" and impending "three years since Bear Stearns went down" articles, the S&P 500 is, shockingly, at about the same multiple of forecast profits as in March 2009. That should offer downside support.
With a mature corporate profit cycle and a resurgent financial-engineering and merger-and-acquisition calendar raising company-specific risks and benefits, chances are we'll soon see the macro/ETF trade ebb in influence versus stock-by-stock selection.
THE DRUBBING ENDURED BY Visteon (VC) shares upon an earnings shortfall and an outlook for greater cash usage in the coming year shows that post-bankruptcy companies are denied the benefit of the doubt. Yet the Asia-focused auto-parts maker, featured bullishly here in late November, remains an underappreciated good bet on the global car cycle. Visteon finished Friday at 65.16, down from 74.99 a week earlier. Kirk Ludtke of CRT Capital, who carefully follows all the post-restructuring auto names, upgraded the stock to Buy and believes it's worth $82 based on updated 2012 car-sector forecasts.
E-mail: michael.santoli@barrons.com
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