Straight Thinking About ETFs

You probably know that index funds and index ETFs are no longer just popular with financial planners and other insiders. Word has gotten out to the investment public about how difficult it is to beat the market, and how many index funds beat the majority of actively-managed funds—especially the expensive ones.

But there’s a persistent worry in the investment community about what would happen if the majority of investor dollars were to roll into index funds and ETFs. These funds don’t research the underlying fundamentals of the companies they invest in; their charter is simply to hold each stock in the same percentage as the index. If that’s where most of the money is, who is left to determine what is and is not a bargain, what stock is over- and undervalued—a process called “price discovery?” With all the fund flows into passive investments recently, is it possible that we already don’t know the real value of the stocks in our portfolios?

A recent interview with Alex Bryan, the director of passive strategies research for the Morningstar organization, puts some of these worries into perspective. He acknowledges that if the markets are not efficiently priced, investors could end up owning big stakes in stocks that are overvalued—something that actually happened in the late 1990s, when tech stocks suddenly made up 40% of the S&P 500 solely due to their high share prices.

But Bryan notes that today, although index funds have about a 40% share of investor dollars in the U.S., they make up a very small part of the overall trading volume of stocks in the marketplace—because of their low turnover. That means that most of the trades, which is where “price discovery” happens, are still being made by active fund managers and individual investors.

There are, however, disruptions when an index “reconstitutes,” meaning that some stocks drop out of the index and others take their place. These changes are announced in advance, which basically means telling the world that the index funds and ETFs which mimic that index are going to have to sell certain stocks and buy others. Because these sales are basically forced, it means that investors know that the stocks going into the index are going to get a bump in price, and they invest ahead of the purchases—which actually raises the price a bit further, and makes the index fund less efficient. The same thing happens with the stocks that have to be sold, but in reverse.

One solution is to own a total market index, which buys the whole market and, therefore, doesn’t have any forced purchases or sales. The index funds and ETFs, themselves, are addressing this problem by applying a wider buffer zone. So if a company fits the definition of a small cap stock, and then has a good day on the market and trades at a higher price that would bump it up into the midcap space, a midcap fund might decide to wait to add it to its holdings. If the stock bounces back down into the small cap range, there is no trading activity.

Bryan’s overall conclusion is that we are not in dangerous territory—at least not yet—regarding index ownership of stocks. How would we know when we cross that invisible line? If the markets suddenly become less good about valuing companies (and, therefore, their stocks), then the smaller number of active fund managers who are left in the marketplace will have a field day identifying misplaced securities, selling those that are overpriced and buying stocks that are trading significantly below their real market value. The result would show up in a resurgence in active managers beating passive indices, who would attract flow of dollars from investors, and the problem would correct itself.

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