Hey lions and lionesses.

Today I debunk the myth of ETFs and passive investing distorting markets.

I also poke fun at Black Friday math.

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Take care out there.

Personal Finance

A fun video I shared on Instagram as Black Friday rampages people’s wallets.

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Stock Markets

Are ETFs and Passive Investing a self reinforcing loop that distort stock prices and therefore undermines the credibility and true price discovery of the stock market?

I had a question from a long time loyal reader about this and so I put some thought into my response as follows.

First, when I started in the money management industry years ago ETFs were still up and coming but it wasn’t very long before advisors and analysts started sounding the alarm bells about the rise of passive investing and ETFs distorting prices on the basis that ETFs must buy the stocks in the index.

It’s a fair thought, but it is also flawed and shows that not many people truly understand how ETFs work. I remember going through this dialouge with my then boss and lead portfolio manager on this subject because we would largely allocate our US equity exposure to the S&P500 etf instead of bothering with stock picking or active fund managers (which is more useful in less efficient markets like Canada and developing markets for example).

And what I leared then I had forgotten how to repeat in said disucssion with this reader so I did some back channeling and research that will help illuminate the fallacy many people have with the ETF impact on quote unqote artificially inflating prices.

First, ETF providers don’t go out and “buy every stock in the index” when you buy one share of VOO (Vanguard SP500 Index).

ETFs are traded on exchanges and there are millions and billions of orders on the desk for both buyers and sellers that have lined up with their price to buy or sell.

99% of the time, when you are buying one share of VOO, you are buying it from someone else.

The best analogy I can think of is buying and selling houses. You trade a deed with someone else, the building itself stays the same (nor cares who’s in the house).

However, where things do change is when a very large order - let’s say Saudi Soveriegn Wealth Fund buys $50 Billion of VOO. The ETF liquidity is obviously not that deep, so the order get’s absorbed by new ETF shares being created by the trading houses.

This is where some people will make a mistake and say, ok now this is an example of ETFs distorting prices if we are talking about major flows and new shares being created.

But that’s not true either.

Whether Saudi bought all 500 stocks on the exchange individually, or bought the ETF, it is essentially the exact same impact.

The new capital may increase the market cap of each stock - obviously! - because net new capital into anything, or when there are more buyers than sellers, can push prices higher.

So the argument on ETFs distorting price discovery is actually flawed when you look a little deeper.

However, I will say this, the growth of capital flows toward passive investing—meaning, boys and girls like you and me—does have an effect on pricing mechanics.

Why? Because passive investors are price takers in general. Meaning, no one is analyzing Apple’s margins, or NVIDIAs cash flows and Return on Invested Capital when they buy the index. If we imagined a world where 100% of investing was of the “passive” format, and the true price setters, i.e. active managers, were literally extinct, then yes, we could be in an investing world where security pricing is a self reinforcing distorted price arena, not reflecting what the Buffet’s of the world would determine fair value.

But because capitalism is pretty incredible and there will always be wannabe Buffets, so too there will always be active money in the market. Hedge funds, pension funds, mutual funds, small cap managers, retail traders, arbs, etc, that identify undervalued securities to buy, or short sell over valued securities that they believe have run too far. It is really their trades that move markets toward fair value over time.

Remember the quote from Buffet: “in the short term markets are voting machines, in the long term markets are weighing machines.” 

And finally, while some would argue that passive funds have grown significantly through time, when you look under the hood, index funds own only a minority share of US market capitalization anyway.

To conclude, it appears the risks of ‘passive index investing’ are not as bad as many people think.

Sorry if this got lengthy and a bit technical, but sometimes I have to.

And keep buying market ETFs people!

Some useful sources that helped my research:

CFA Institute - ETFs: Mechanics and Applications 

Vanguard Research - The Truth About Index Fund Investing

Real Estate

Been looking at more and more deals lately, which is encouraging, though still much the same story even as interest rates have abated somewhat.

Which is to say our pricing criteria is strictly disciplined such that asking prices today are still far higher than we’d be willing to pay.

At the end of the day, we will not buy real estate just to buy real estate.

There has to be a story, especially when you are raising money from sophisticated high net worth investors. Who, by the way, over the past 4/5 years have experienced some pain in the otherwise flawless performance they sustained for the 1990 to 2021 period (office, development, condos, private real estate funds like Nicola, Centurion, etc).

Therefore, cost of equity capital is still high. By that I mean specifically ours. There are still groups of doctors and dentists and that “just want real estate” and will unkowingly over-pay for the building we are evaluating.

At any rate, given the increase in transaction volume, perhaps the asking prices will meet the bid prices as owners look for liquidity.

Stay tuned.

1 Quote

"Life is like riding a bicycle. To keep your balance, you must keep moving."

Albert Einstein 

A Question

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