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Is the Tail Wagging the Dog?

So many investors have been bailing out of actively managed mutual funds and piling into index and quasi-index funds via exchange-traded funds (ETFs) that, as Bloomberg Business Week points out, we’ve reached the point where there are now “more cartons than eggs.” That is, “the number of market indexes” [most created for ETFs to track] “now exceeds the number of U.S. stocks.” This most recent stampede has long precedent: When investors want something, Wall Street supplies it—and, eventually—more than they need. And, perversely, just when many/most investors think they have finally figured out how to play the game, somebody changes the rules.

That indexing’s low costs meaningfully boost returns is, by now, universally understood. While index funds have been around for decades, the introduction of ETFs has ramped up enthusiasm because it has made investing even cheaper and easier. In their recent shareholder letter Tweedy, Browne points out that… “the largest exchange-traded fund today, the SPDR S&P 500 ETF with assets of approximately $240 billion, has had a daily turnover in its shares that routinely approximates 5–10% of total shares outstanding. That translates into 100% plus turnover in its shares every month.”

Another set of statistics that gave me the collywobbles was reported June 29, 2017, in the Wall Street Journal: “On June 9…when strong-performing technology stocks abruptly suffered their worst declines in nearly a year, trading volume in the PowerShares QQQ ETF—which tracks the Nasdaq-100 Index—surpassed $15 billion and the ETF fell 2.5%. A day later, the ETF experienced an outflow of $1.9 billion.” In other words, with total assets of $50 billion, on one day the fund turned over 30% and the next day the outflow was almost 4%!

In a November 2015 column titled, Indexing’s Noble Lie—Why Proponents of Passive Investing Make False Claims, Don Philips, managing director of Morningstar, wrote, “Indexing is a great tool, but it is not a panacea for all investment problems. Index funds can be easily misused, as seen in the euphoria around the QQQs in the 1990s or the flood of hot money that went into Vanguard’s large-cap growth index fund in 1999.”

Both suffered steep declines.

Philips urges discipline. In other words, deciding on an overall strategy and then what to invest in and when. He continued, “That, I believe is the only favorable light in which one can justify the ritual overstatement of the case for indexing. This noble lie is especially important to users of cap-weighted index funds, which by definition have maximum exposure to the most overheated parts of the market at their absolute peaks.”

Clearly, indexing is here to stay, but have too many investors decided that, as Western Airlines (absorbed by Delta Airlines) claimed, is it “the o-o- only way to fly."? Rather than being the solution, I suspect that some ETFs might turn out to be a problem that nobody is paying attention to. The two-day QQQ trading volume in June may have been a warning. “Both the trading volume and withdrawal were the biggest moves in a decade,” according to the Journal.

Many investors believe that ETFs have conquered their investment challenges, but have they become this bull market’s fad? Is there too much complacency? I would submit that as much as they have improved the investment process for average investors, their marginal benefits do not solve the most basic challenges: what to

invest in and when.

The ETF wave keeps building. A Goldman Sachs analyst calculates that “ETF demand for equities surged to $98 billion in the first quarter, putting 2017 on pace to exceed total demand in 2015 and 2016 combined.”

Indexes are designed to exhibit returns, to provide benchmarks for sectors, strategies, investment styles or the broad market. But instead of benchmarking, could the massive trading volume of ETFs’ indexed, cap-weighted, computer−driven architecture begin to drive the indexes, rather than the other way around? Are the tails—the ETFs, beginning to wag dogs—the indexes? When this market cycle ends—and it will, rising stock prices will inevitably roll over and begin to drop.

And, since rapidly growing ETFs have added more and more propellant for rising prices, is it logical to expect that, in a falling market, ETF price-propellants will turn into price-accelerants?

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