November 21, 2011 / 5:11 PM / 7 years ago

Insight: ETFs, events trip Legg Mason star Bill Miller

NEW YORK (Reuters) - Bad decisions did Bill Miller in over the past five years.

What has hobbled his comeback is a market where exchange-traded funds and trading are king, while calculating the real value of assets holds little appeal.

As manager of the Legg Mason Value Trust for nearly three decades, Miller’s forte was his ability to assess the prospects of businesses heading into uncharted waters. Few others could fathom the outlook for AOL, and Google like Miller, whose analysis of future growth paid off in spades.

His downfall was his myopia to macro events, from the rise of the commodity boom to the depth of the financial crisis, which kept him from seeing opportunities in energy shares or avoiding doomed bets on housing and financial stocks.

Yet Miller’s dismal record since 2006 is also due to a new dynamic in the stock market. After the deepest downturn since the Depression, a singular focus on macro events is pushing almost all assets to trade in lock-step.

Miller’s exit - he said last week he would step down in April from Value Trust, a fund that outperformed the S&P 500 Index .SPX for a record 15 straight years - comes at a time when there is little differentiation in asset valuations.

Driven by the uncertainty spawned by the financial crisis of late 2008, a “risk on, risk off” world view has pushed almost all assets to trade in tandem. It has paralleled the rise of the exchange-traded fund, a security that makes stock picking less relevant.

“Markets can go into these phases where strategies which are pretty robust can come under a lot of pressure, and I think that’s clearly the case now,” Miller told Reuters in an interview. “I love the values in the market. I hate the way in which these things are trading.”


ETFs have more than tripled in the size of assets to just over $1 trillion since 2005, Miller’s last year in his winning streak, and now account for as much as 40 percent of trading, according to Credit Suisse and other sources.

The dominance of ETFs has led to questions about their role in a highly volatile marketplace. While industry experts insist ETFs are not behind the surge in volatility - they say uncertainty over the economy is to blame - ETFs have boosted a “trader” mentality in the marketplace.

An array of securities is now available to bet on a sector or the overall market’s direction. The market impact can be extensive as less liquid securities get pushed around, distorting their price and that of the indexes they comprise, said Lionel Mellul, co-founder of Momentum Trading Partners LLC. His brokerage specializes in pairs execution and basket trading that critics also say boosts stock correlation.

“Any heavy activity in ETFs will also have an impact at the sector level and carry through to the broader index,” Mellul said. “Essentially you trigger a shock wave on all the components.”

Mellul points to October 18, when a late-day surge drove the benchmark Standard & Poor’s 500 Index .SPX up a tad more than 2 percent for the day, propelled by financial-sector gains that were more than double the market’s overall rise.

Almost 23 million shares of the Select Sector SPDR Financial were traded in the five minutes before the regular trading session closed, accounting for one-eighth of the ETF’s total activity that day.


The high degree of uncertainty has driven correlation levels in U.S. stocks to all-time highs — 85.9 percent of U.S. large-cap stocks rise when the overall market is up, or vice versa, according to Bianco Research in Chicago.

Trading is often thin, too, with liquidity - the ability to easily find a counterparty to a trade - often greatly reduced, a number of traders and portfolio managers say.

“You’re seeing very sharp movements in stocks, without any apparent news, simply because a buyer or seller is moving it fairly dramatically without the normal liquidity flow to offset it,” said Rick Meckler, a co-owner of hedge fund LibertyView Capital Management LLC, in Jersey City, New Jersey.

Mom and pop investors have withdrawn more than $100 billion this year from mutual funds that invest in U.S. equities, according to data from the Investment Company Institute, reducing a key element of support for stock trading, Meckler said.

Liquidity ebbs and flows because of volatility, and the two move in tandem like a seesaw: Low volatility means greater liquidity while increased volatility reduces liquidity.

“Until the market returns to some sense of normalcy, in terms of normal volatility, you are going to see reduced liquidity even in the large names,” Meckler said.

Since August 1, the S&P 500 Index has advanced or retreated 1 percent or more in two out of every three trading sessions.


Many people blame the high correlation and volatility on ETFs, in particular those that are leveraged or provide an inverse return on the market’s performance.

These funds saw record investment flows in August and September, and relative to their size, have attracted more fresh money this year than any other investment category, data from State Street Global Advisors shows.

Others say blaming leveraged funds is misplaced.

“What we’re seeing today is not anything different than what happened during the bursting of the Internet bubble, in the aftermath of 9/11 and the erosion of the housing market and the housing bubble,” said Richard Keary, principal at Global ETF Advisors LLC, a consulting firm that specializes in ETFs.

“There’s always been some sort of culprit out there that we blame,” said Keary, a former trader who helped create the Nasdaq ETF Market, “and the easy ones to blame are the inverse and leveraged ETFs.”

Access to ETFs has given investors a feeling that they should be more active in the market than they otherwise would be, which is adding to volatility, said Jason Browne, chief investment officer at DAL Investment Co in San Francisco.

“People are jumping on that train or jumping off that train, and it’s extenuating the moves,” said Browne, whose firm invests solely in ETFs and mutual funds.

“They’re being induced to trade more, they’re being encouraged to trade more and they are trading more,” he said.

Miller said that valuations become more normal around earnings season, when correlations tend to subside. But once results have been released, the correlation shoots back up.

“The ability of stocks to separate based on valuation is much less than it used to be,” he said. “Earnings give people a chance to recalibrate, but then everything starts to trade together again.”

Many stocks are priced well below what their earnings imply, Miller said. Apple Inc (AAPL.O), for example, is trading at less than 10 times its earnings for the next 12 months and is sitting on a growing pile of cash. If the cash is taken into account, its P/E ratio is about 8 1/2 percent.

“Does that make any sense for a company that still has a very low global market share in its core area? It’s growing like a weed and it’s got a great reputation.” he said.

“There’s no financial risk at Apple with $80 billion. Not a lot of people are worried about that,” he said.

Reporting by Herbert Lash; Editing by Jan Paschal

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