Index Investing Economy

Index Investing Economy can have some problems.

I always recommend investing in market indices (ETFs) to save costs and time. But this way we are not creating a bubble around them.

A few years ago Michael Burry gave an interview in which he stated that ETFs were creating a bubble.
As long as the speech is September 2019, his speech may still be valid. After all, investors’ fears remain.
Michael Burry was based on 2 concepts. The index effect and the distribution of daily dollar value traded.

The index effect is based on the fact that a company as soon as it enters an index gets a lot of buys. Increase in demand –> increase in price. However, this effect no longer seems to have strength in recent years, probably also thanks to ETFs.

Also in case the stocks are really overvalued and the replica ETFs are forced to imitate the index. Active fund managers would have even more potential for earnings given their ability to disengage from the index.

Regarding the second point Michael Burry says

The dirty secret of passive index funds — whether open-end, closed-end, or ETF — is the distribution of daily dollar value traded among the securities within the indexes they mimic

and continues

The S&P 500 is no different — the index contains the world’s largest stocks, but still, 266 stocks — over half — traded under $150 million today. That sounds like a lot, but trillions of dollars in assets globally are indexed to these stocks.

The bottom line is that if everyone wanted to sell their shares there probably wouldn’t be any buyers for everyone.

However Burry does not take into account 2 things:

  • An ETF does not need to buy all the stocks within an index in order to track it correctly. Sampling tracking ETFs buy only the stocks that move the index the most (usually outside the half mentioned by Michael Burry) and with mathematical calculations are able to track the underlying index. This is also great for lowering ETF costs, fewer stocks traded, less costs.
  • 90 percent of the volumes are in the secondary market the ETF doesn’t have to sell its underlyings every time someone sells an ETF. However, let’s assume that there is a mass sale of the ETF, because the index no longer satisfies. Should the ETF depreciate more than the underlying then a third party called an authorized participant comes into play. In such a scenario the authorized participant will buy ETF shares from the secondary market then from the seller and then go to the issuer who issued the ETF shares to request the redemption of those shares. This mechanism is called creation and redemption in kind. It is the foundation of how an ETF works, and it is primarily the mechanism that allows an ETF to track the index so closely during major market shocks. I leave you below an article by JustETF that explains it.

I would also add that being passive investments, investors tend to remain more anchored to their instrument even during market crashes. (Disposition Effect?)

Be careful because the above discourse does not apply to all ETFs. If you buy exotic ETFs or leveraged, inverse or SWAP-based ETFs, there may be counterparty risk. You don’t have to play with them.

What if everyone invested in an index

When I talk about Index Investing Economy I mean an economy in which everyone invests in passive funds and robots alone determine share prices.

However, I think there are no worries. Some reasons:
1) Active investors will never disappear, because most people will never accept that they are just “average”. They think they can beat the market, and they will try. In the same way that people play the lottery, it doesn’t make sense economically, but it’s there.
2) Many investors now do “index picking” instead of “stock picking”, and it helps to set prices.
3) The same company could be in many different indices: large cap, socially responsible, economic sector X, country Y, value, weight parity, dividends, etc. A large number of indices can help set the prices of individual stocks.

4) Institutional investors will always look for strategies to beat the market or to be less volatile. They do it for their budgets, not for the common good.

For the reasons listed above, I wouldn’t worry about the Index Investing Economy or an ETF bubble.

Long and complicated topic of which I think I have gutted all the points a bit, but which I don’t reserve the right not to write again in the future.
If so, I’ll update this post.

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