Indexing is passive investing; commonly referred to as ETF investing. The objective of an ETF is to replicate the performance of a specified Index.
Since 1995, ETF share of all US equity assets has increased from 5% to 26%, according to Goldman Sachs. Clearly they are very popular.
For us, ETFs are problematic because ETF investing runs counter to three of our 5-Enduring Principles.
1. We believe original price paid is the most significant factor guiding future rates-of-return for an asset.
ETF manufacturers don’t focus on price. For them, liquidity is paramount. Accordingly, certain things we view as positive are a big negative in the ETF world.
For instance, heavy insider-ownership is a positive for us—we believe owners are more apt to do the right thing than renters—but for an ETF it can be a big negative because it reduces float, i.e., liquidity.
2. We believe reversion-to-the-mean is the most powerful force in finance.
In ETF investing there’s no mean to revert to. Within an asset class, ETFs are the mean.
3. Careful investment selection trumps random diversification.
Capitalism produces winners and losers. ETF investing means owning both the winners and the losers, the ‘good, the bad and the ugly,’ so to speak.
We believe in focusing instead only on the good.
Apart from violating our investment philosophy, there is another problem with ETF Investing: it’s subject to the “Law” of Reflexivity.
Evidence is building that many ETFs no longer just mimic an Index, but instead influence the Index itself.
ETFs don’t simply reflect reality, they drive it. That’s Reflexivity.
Concern about Reflexivity for commodities has been part of an ongoing debate—including the current one about copper in the US Senate—as to ETF’s role in promoting boom/bust cycles.
In the stock market not much has been made of this phenomenon. Recently, however, Murray Stahl demonstrated that companies popular with ETF-manufacturers are more expensive than those that are not popular.
In an example used, ETF-popular firms were both financially weaker than, and twice as expensive as, the ETF-unpopular ones.
This is an important insight that has us thinking through its implications.
No doubt it will lead to creative applications. An ETF comprised of ETF-unpopular stocks perhaps?
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