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Do ETFs Lead to an Overvalued Market?
Old 07-31-2017, 09:26 PM   #1
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Do ETFs Lead to an Overvalued Market?

I had read recently about Jack Bogle discussing the over-saturation of ETFs in the market and the consequences of this strategy when applied by so many investors at once. He seemed to claim that if everyone were to invest only in ETFs, it could defeat the purpose and value of ETFs.

I'm interested to hear other people's opinions about this theory. It seems logical that if ETFs become too prevalent, the market then becomes artificially inflated because people are investing in every stock rather than just the ones that are really performing. The statistical underpinning of the ETF strategy would start to fall apart because the benefit of ETFs depends on the market behaving normally.

I wonder at what level of investment ETFs will start to become counter-productive. Forbes claims there are $4 Trillion invested in ETFs worldwide. I wonder if we are already there? It makes sense it would be predicated by higher than average P/E ratios for the market as a whole.

It actually seems to predict that the ETF strategy will eventually disappear [or at least diminish significantly with a market crash] Perhaps it could be the cause of the next big market correction. (It is a newer innovation - ie. post-'09 - that has grown well beyond its intended purpose.)
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Old 07-31-2017, 10:30 PM   #2
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Disagree vehemently. If 99% of money were in index investments, then one percent would be out there makng bets and setting prices and getting excess return. And hell, etfs contain triple leveraged commodity plays and everything else .
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Old 07-31-2017, 10:40 PM   #3
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In theory, yes, too much concentrated investment in any one thing would lead to imbalance in the market. I believe he was referring to specific ETF's like replicating the S&P500 only. Fortunately the makeup up today's ETFs are broad range of all types of investment vehicles, incl commodities, real estate, bonds, etc.
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Old 07-31-2017, 11:07 PM   #4
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Tell all your enemies to invest in actively managed funds. This way the index funds are safe.
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Old 08-01-2017, 12:23 AM   #5
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Disagree vehemently. If 99% of money were in index investments, then one percent would be out there makng bets and setting prices and getting excess return. And hell, etfs contain triple leveraged commodity plays and everything else .
So 99% would lose and 1% would clean up. At some point the incentive to move to stock picking overwhelms the passive ETF strategy. The question is, at what point?

Here's an interesting article on the topic...it suggests 20% of the market is owned by ETFs and a much higher concentration in certain industries like airlines where it's creating shareholder monopolies - something new and wonderful unknown.

Is Passive Investment Actively Hurting the Economy? | The New Yorker
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Old 08-01-2017, 07:05 AM   #6
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As I read Bogle's comments in a recent interview his lack of comfort with ETFs centered on the trading tendency of many holders, not the fact that they were in indexes. He thinks index investors are better off using a buy and hold approach, not active trading.
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Old 08-01-2017, 09:36 AM   #7
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Last week's Freakonomics podcast was about indexing/ETFs/etc and had Bogle as one of the guests, also Scaramucci (recorded before he was hired/fired by the white house). I don't think the sophisticated investing crowd here will learn a lot of new info, but I enjoyed hearing Bogle's stories and some discussion of the fiduciary rule.

Here's a link to the episode and transcript. They transcribe ETF as E.T.F. if you want to search for that part of the discussion.

The Stupidest Thing You Can Do With Your Money - Freakonomics Freakonomics
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Old 08-01-2017, 10:07 AM   #8
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More money invested in ETF's & low cost investor direct access funds is less in brokers pockets & thus more in the market. So, yes, I think investing thru ETF's raises market prices.
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Old 08-01-2017, 02:57 PM   #9
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Whew. Lots of stuff here.

First, not all ETFs are index funds. I looked a year or so and 20% of 1,000 were stock pickers. Probably it's more now. Conflating ETFs and Index Funds leads IMO to confusion.

Second, what is "the market?" To me it is worldwide tradeable equities, the ACWI All Cap for example.

The herd mentality on passive investing is to buy an S&P 500 index fund. So if the question is: " Do S&P 500 ETFs lead to an overvalued S&P 500?" the answer is clearly yes. If that weren't true it wouldn't be a profitable strategy for traders to front run additions and deletions from the S&P 500, yet this is a popular sport. I do not, however, have any idea how much the overvaluation is. Neverthless, I would not consider an S&P 500 index investment. It is bad enough that I can't avoid the S&P 500 sector by buying an ACWI All Cap index fund.

If the question is "Do ETFs as a whole lead to an overvalued ACWI" I think the answer is another question: "What does overvalued mean?" If a bunch of investors are bullish and buying stocks, there's no news there. This has been going on for a couple of centuries and it does raise market prices. But "overvalued" I don't know. The Efficient Market Hypothesis would say no. Believers in "irrational exhuberance" would say maybe. But regardless, it is not the EFTs' fault. They are just an investment tool.

Ref the Freakonomics piece, I'm not going to listen again but what I remember was a very well founded argument that people trading ETFs are not passive investors and, BTW, not particularly smart ones either.
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Old 08-01-2017, 05:47 PM   #10
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... the market then becomes artificially inflated because people are investing in every stock rather than just the ones that are really performing. The statistical underpinning of the ETF strategy would start to fall apart because the benefit of ETFs depends on the market behaving normally...
No, it is not about the whole market getting overvalued, but about no distinction between bad stocks and good stocks. Yes, bad stocks would be overvalued, but then good stocks will be undervalued.

I do not know what Bogle said about ETF, but in the following piece he was talking about indexing, and whether that can change the market efficiency.

You see, when you buy a basket of stocks, with the proportion of stocks predetermined (5 apples + 2 oranges + 3 prunes + 1 strawberry, etc...), without regard to whether the apples are rotten and should not be bought, that's what Bogle was talking about.

Right now, individual stock traders determine what an apple should be worth relative to an orange and a prune. They indirectly determine what proportion of each fruit is in the basket that the index investor will buy. If everybody indexes, then rotten apples will always be bought along with all the other good fruits, and bad companies will maintain their values despite being worthless. With nobody rejecting the bad apples, they will continue being bought.

The same effect happens if everybody buys the entire basket of stocks in the universe instead of just the S&P 500. A growing little company that is now 1/1000 the size of a larger company will always be bought at the rate of 1/1000 of the larger company, and its price will not reflect its true new economic value.


See: https://www.bloomberg.com/news/artic...ket-efficiency. An excerpt follows.

“The issue is at what point is indexing making the market less efficient,” said Bogle, 87, in an interview Friday on Bloomberg Television. Indexing, which now controls about 30 percent of the market, “could get to 50 or 60 percent before anything would be noticed.”
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Old 08-01-2017, 06:26 PM   #11
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... You see, when you buy a basket of stocks, with the proportion of stocks predetermined (5 apples + 2 oranges + 3 prunes + 1 strawberry, etc...), without regard to whether the apples are rotten and should not be bought, that's what Bogle was talking about.

Right now, individual stock traders determine what an apple should be worth relative to an orange and a prune. They indirectly determine what proportion of each fruit is in the basket that the index investor will buy. If everybody indexes, then rotten apples will always be bought along with all the other good fruits, and bad companies will maintain their values despite being worthless. With nobody rejecting the bad apples, they will continue being bought. ...
The key word in the second paragraph is "If." IMO everybody indexing will never happen, primarily because hucksters have to eat and they will continue to have a degree of success pitching active investments and portfolio management wrap fees to the ignorant and the insecure. Everyone knows that on average casino play and lotteries are losing propositions but human nature, greed and optimism, will keep them in business forever. The same emotions are evoked when gambling and when trading stocks.

The other consideration is that passive funds do not trade very much. 5% or 10% turnover per year maybe. Active investors trade like gnats on speed, 100%, even 250% per year. This means that even if the active traders are a numerical minority like 20%, their trades will still dominate the market action and provide the holy grail of "price discovery." So they will be identifying the rotten apples and driving their price down relative to the good fruits.

IMO most of the smoke about the evils of passive investing and the ghost stories about what the future might hold are simply the inventions of desperate people whose livelihood depends on the phony baloney of consistently beating the market. Note that this this band of hucksters is much bigger than the actively managed mutual funds. It is the AUM-seeking managers, the newsletters and web pages like Motley Fool, and print magazines like Barrons.
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