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Are ETF's and indexing a bubble?

I get this question from clients, friends, and acquaintances once every few months or so. "Indexing is becoming more and more popular," they say. "Vanguard is huge. This must be a bubble. Michael Burry from The Big Short said so!"

It's a valid question, for sure. So let's take a look. But first, let's understand the potential problem.

How markets -- and bubbles -- work

Remember ECON 101? One of the first things we learned back then was the purpose of traders: to set prices. If someone is selling something for less than it's worth, the trader quickly snatches it. If someone is willing to buy something for more than it's worth, the trader immediately fills that need. The supply of undervalued goods and demand for overvalued goods diminishes, as savvy traders bring the market towards an equilibrium, making the market more efficient. They "discover" the value of the thing being traded: the equilibrium point where supply and demand meet. This was true long before there was this crazy thing called the "stock market".

On stock valuation

So what's value of a share of stock? The answer is deceptively simple: the value is the excess company profit that the stock entitles you to, i.e. its dividends. In that way, bonds and stocks are quite similar: you're putting up money now to buy the rights to a stream of income in the future, whether that stream of income is dividends or interest. That's it. That's all owning a stock or a bond gets you, so that's where all the value comes from.

This is a key point. Because you're buying a future income stream, the value of the stock needs to take into account not just the status of the company in the present, but also as far into its future as possible. (This is why stock in companies that don't yet offer dividends is still worth something; the assumption is that they may offer dividends, eventually.) Of course, there are many possible futures: the company may go bankrupt, or it may go Amazon, or it may trundle along roughly where it is.

And here's the fun part: the value takes into account all of these futures. Some people are betting the company will do well, and assigning a high value to its stock; some are betting the other way, and assigning a low value. As they trade back and forth, the value ends up being something like a weighted average of possible futures; the more likely a particular future is, the more the value of a stock will reflect that future. (Kind of reminds you of quantum mechanics, doesn't it?)

A sidebar on speculation

Note: this is why you need to be very careful speculating on stocks. "Hey, there's a quarantine going on -- I bet video conferencing software will go gangbusters!" Well, perhaps -- but as soon as the quarantine went down, in fact even before COVID-19 was declared a pandemic, that possible future was already creeping into the price. Take a look at ZM over the first four months of 2020 if you want to see what I mean. When you speculate on a stock, you're speculating not that a company will do well or poorly, but that the market is wrong about future probabilities. This is dangerous! You may indeed outguess the market once or twice, just like you may win a few hands of blackjack, but research has shown time and time again that attempting to do it consistently is a loser's game, like playing against the house.

It's kind of like that game where you guess how many marbles are in a large jar. You may not know this, but if you gather a large number of people together in a room and ask them all to guess how many marbles are in there, the average of all the guesses is very often remarkably close to the actual number of marbles, as James Surowiecki discovered and wrote about in The Wisdom of Crowds. And in the stock market, you're not betting against people in the room -- you're betting against nerds who decided not to go to Google because it didn't pay enough. Do you feel lucky, punk?

OK, so what's a bubble?

Notwithstanding that, occasionally the market is -- simply put -- wrong about future probabilities. Sometimes this is simply because the future doesn't play out the way we expect; we expected the World Wide Web to revolutionize business in the late 90's, and while we weren't entirely wrong, we underwent a massive reset of expectations in 2000. And sometimes this is because a rare and world-shaping event happens, like a global pandemic: the future becomes extremely murky as we gather data about the nature of the virus, its effects, and the global response.

Sometimes, though, a bubble might be because that "price discovery" mechanism I mentioned earlier isn't working the way it should. 2008 was a pretty clear example of that: collateralized debt obligations were so opaque that they priced higher than their inherent risk would dictate, and the market didn't realize this until people started defaulting on loans in the wake of ARM rates rising.

So are passive investments a bubble, then?

And now we come to indexing and ETF's. The argument here is that indexing, ETF's, and other such "passive" investing vehicles are opaque, like CDO's: people buy them without considering the inherent value of the stocks they contain.

Now, ideally this is a non-issue: there should be enough active traders who are evaluating each stock individually such that any gap between a passive investment's market value and its "actual" value is quickly closed. But it's theoretically possible that the tail could start wagging the dog (ref. CDO's!), so let's examine the hypothesis. Larry Swedroe did an excellent analysis, which I'll go over here.

For one: if indexes are distorting prices, than the active players should be making absolute bank, taking advantage of ever-increasing arbitrage opportunities to buy low and sell high. That doesn't seem to be the case, though; according to a 2014 research paper in the Journal of Portfolio Management, the percentage of outperforming "skilled" managers dropped from 20% in 1993 to 1.6% in 2011. So, no. Rather, it seems that active traders are doing their job, and that increasing availability and rapid dissemination of information is making them ever more efficient in discovering price.

Another indicator of distortion by passive investing would be that the value of all stocks in a given index would start rising and falling by roughly the same value, as their price is determined by their index, rather than their value. In 2017, the spread of stock returns in the S&P500 ranged from 132.3% (NRG Energy) to -53.9% (Henry Schein, Inc.), with a wide distribution within this range. So again, no -- active traders seem to still be doing their job.

Of course, this even assumes that there are actually fewer active players attempting to outperform. If so, we'd expect trading volume to go down, as active "price-making" is replaced by passive "price-taking". This turns out not to be the case; global trading volume continues to rise.

All this jives with market theory, as summarized by Richard Posner and John Langbein a few decades ago: in general, even markets like homes, consumer goods, etc. that don't have the straightforward pricing model (see above re: the value of a stock), frequent trading, centralized bids and offers, and other features of the securities market are reasonably efficient. So we expect that it shouldn't take many active players to keep the stock market running smoothly.

So this turns out to be one of those cases where Adam Smith's invisible hand is working as advertised: because of traders' desire to make money, any opportunity to buy low and sell high is quickly identified and taken advantage of, keeping the market running with hyper-efficiency, despite the presence of passive investors in the market.

Which is good, because passive investing is a lot cheaper than active investing, and since the markets seem to still be efficient, that's money in your pocket!

Britton is an engineer-turned-financial-planner in Austin, Texas. As such, he shies away from suits and commissions, and instead tends towards blue jeans, data-driven analysis, and a fee-only approach to financial planning.

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