Horizon Kinetics: The Failure of the ETF Phenomenon

  • The largest ETF in the energy field is the SPDR Energy Select Fund (XLE), with about $18.3bn in AUM
    • For the 12 months ended 3/31/18, the return was -0.39%
    • A year earlier, WTI was trading for $50.54/bbl; on the last day of trading in March 2018, WTI traded at $64.87/bbl; this is an increase of 28%, and it is fairly self-evident that most energy company profits will rise enormously when the first quarter 2018 profits are reported in relation to the first quarter of 2017
    • Yet, XLE shares trade at essentially unchanged prices
  • Top 5 holdings in the index:
    • ExxonMobil: 22.99%
    • Chevron: 17.08%
    • Schlumberger: 7.01%
    • ConocoPhilips: 5.06%
    • EOG Resources: 4.63%
  • More than half the fund is composed of five stocks. If XOM were merely an energy stock, the phenomenon of unchanged prices in a time of a dramatic increase in energy prices would be incomprehensible. Yet, XOM is not merely an energy stock. It is a significant presence in many indexes, of which we will only mention a few:
    • FDL: 9.53% weight
    • HDV: 8.61% weight
    • JKF: 5.28% weight
    • DGRW: 5.15% weight
    • DHS: 4.92% weight
    • SCHD: 4.80% weight
    • PFM: 4.15% weight
  • From the list of ETFs that include the company, we discover that XOM can be a growth stock, it can be a value stock, it can be a quality stock, it can be a yield stock
    • XOM can be many things, because being something is apparently in the eye of the beholder
  • At the end of March 2017 when oil was at $51, XOM traded at $81/share, and at the end of March 2018 with oil higher, at $64/bbl, XOM traded lower, at $73/share
    • This is because the XOM shares in their utility for indexation purposes as a bond-substitute in dividend yield ETFs, in dividend growth ETFs, etc – separate from XOM as an energy business – are worth less money since the 10-year Treasury yields more at the end of March 2018 than it yielded at the end of March 2017
  • XOM is forecasted to earn $4.81/share in 2018; at the end of March 2018, the shares were trading at a P/E of 15.8x; the estimates are based on the presumption of a $60/bbl price for 2018; as of April 13, 2018, WTI trades at over $67/bbl and Brent is trading at over $72/bbl
  • Assume that in March 2017, an active portfolio manager with profound knowledge of the energy industry correctly forecasted a substantial increase in oil prices and overweighted the portfolio with energy stocks
    • The self-evident result would have been underperformance
    • It should be stated that the XOM share price did not substantially decline as energy prices declined from over $100 in 2014 to about $40/bbl at the low
    • This is because even then XOM was classified, for indexation usage, as more than simply an energy stock or a dividend stock
    • One cannot purchase such shares that are in heavy demand, due to their great trading liquidity, by a broad variety of indexes apart from the company’s industry sector, without being cognizant of changes in central bank policies
  • The result of indexation over the long term is that large cap liquid shares, and even small cap liquid shares, especially those that pay substantive dividends, primarily reflect central bank policies, rather than fundamental business conditions, even over the long term
  • Consider the following:
    • IYE (US Energy ETF): inception date of June 2000; ROR since inception of 6.21%
    • IBB (Biotech ETF): inception date of Feb 2001; ROR since inception of 7.18%
    • IVV (Core S&P ETF): inception date of March 2000; ROR since inception of 5.37%
    • QQQ (PowerShares ETF): inception date of March 1999; ROR of 6.84%
    • IDU (Utilities ETF): inception date of June 2000; ROR since inception of 6.86%
  • They all have more or less the same rate of return. The differences in rates of return are more attributable to differences in inception date than to the fundamental attributes of the companies in the funds
    • The companies in question have sufficiently liquid shares that they are subject to excess demand as raw material for indexation’s needs
    • So much so that they have become denatured or commoditized – stripped of their industry – and business-specific idiosyncrasies
    • They reflect, rather, the flows of funds into and out of stocks, which in turn is clearly a function, at these interest rate and valuation extremes, of Federal Reserve policy
    • They have become mechanisms – however inadvertently – of policy transmission
    • They’re no longer companies that have prices that are a function of fundamental values

Horizon Kinetics, April 2018

Image Source: CNBC