Introduction
In light of the preceding
statistics, it is clear that for the typical investor unskilled in evaluating managers,
choosing a fund is a losing bet. At the same time, retail brokerage clients are the most likely candidates to
donate negative alpha to aggregate “gross of fees” stock market returns (aggregate mutual fund performance
looks more favorable on a “gross of fee” basis). Accordingly, to the extent that retail investors move from stock
picking and money manager picking to appropriately chosen ETFs, they may actually be better off. For the
skeptical value investors who require a Warren Buffett quote for validation, look no further than his 2016 annual
letter to Berkshire Hathaway shareholders:
“If Group A (active investors) and Group B (do-nothing investors) comprise the total
investing universe, and B is destined to achieve average results before costs, so, too, must A.
Whichever group has the lower costs will win. (The academic in me requires me to mention that
there is a very minor point—not worth detailing—that slightly modifies this formulation.) And if
Group A has exorbitant costs, its shortfall will be substantial . . . . Over the years, I’ve often
been asked for investment advice, and in the process of answering I’ve learned a good deal
about human behavior. My regular recommendation has been a low-cost S&P 500 index fund.”
U.S. Active Equity Funds: Annual % Outperforming Net of Fees
Source: Credit Suisse Asset Manager Research, Morningstar
Are ETFs Driving Market Distortions?
A common concern voiced by market followers is that ETFs are driving market distortions such as
herding into the best-performing, highest-valued stocks (e.g., FAANGs). The FAANGs (and more recently the
technology sector as a whole) have no doubt been outperforming for years and appear to be attracting
dangerous levels of euphoria among retail investors (and some money managers). But how top-heavy is the
S&P 500? The current S&P 500 bull market rally has actually been much more broadly based than market
pundits appear to believe. Sorted by market cap, the 53 largest companies in the S&P 500 currently comprise
50% of the index’s market value. By comparison, looking back annually to 1980, on average the 51 largest
companies in the S&P 500 have been needed to reach, in aggregate, 50% of the index’s total market value. As
illustrated in the following chart, the stock that accounts for the 50% market cap percentile (at present the #53
stock in the index) currently has a 0.42% weighting in the S&P 500. This is roughly on par with the long-term
average. Clearly, this is a very different market than that seen during the late-1990s bubble, in which market
valuation extremes were more concentrated in tech stocks. In 1999, it took only the 33 largest stocks in the S&P
500 to reach 50% market cap, with the #33 company having a 0.72% weighting in the index.
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Introduction
Weighting of Median Stock in S&P 500, 1980-2016
Source: S&P Dow Jones Indices
In recent years, stocks in the S&P 500 have also demonstrated somewhat above-average correlation
(stocks moving in the same direction over short periods of time) and much lower dispersion (magnitude of
returns across the component stocks, such as measured by the standard deviation of returns) than prior bubbles
or subsequent market downturns. As illustrated in the following chart, in contrast to recent years, the S&P 500
exhibited extremely elevated dispersion and below-average correlation between 1998 and 2001 as the tech
bubble formed. But S&P 500 sector and stock-level correlations have collapsed since the November 2016
election, which has caused a rapid reassessment in the outlook for a variety of factors such as interest rates, tax
rates, foreign exchange rates, and regulations (e.g., health care). This implies that a more attractive market for
stock picking has emerged.
S&P 500 Dispersion and Correlation, 1990-2016
Source: S&P Dow Jones Indices
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Introduction
To what extent are ETFs behind recent market patterns? ETFs are almost certainly creating distortions.
ETFs may be partially responsible for the decline in dispersion and increase in correlation (until recently) among
S&P 500 stocks in recent years, as well as for the concurrent expansion in market-level valuations. But as
mentioned earlier, it is important to understand that not all ETFs are created equal and that the recent collapse
in stock correlations suggests that the sway of passive, broad market-indexed ETFs over market performance is
limited. Putting aside technical issues,
3
truly passive ETFs indexed to broad markets should not be directly
driving major valuation distortions between stocks within the major index such as the S&P 500. (Nor are they
correcting for valuation distortions.) For example, by definition $100 billion (or a sufficiently large value) in fund
flows from the universe of managers who are benchmarked to the S&P 500 fund managers and into S&P 500
ETFs like SPY will generate roughly the same number of Apple shares sold by funds as purchased by the ETF.
To the extent that funds flow from underperforming, alpha donating fund managers/brokers and self-directed
retail brokerage trading into passive, broad index ETFs, this should—perhaps counterintuitively—increase long-
term market efficiency by concentrating market-moving portfolio decisions in the hands of wiser investors.
Whether hedge funds are distorting valuations in the current market is a different question—probably
with a different answer. For example, the Goldman Sachs Hedge Fund VIP Index (which tracks the stocks most
frequently appearing among fundamentally driven hedge fund managers’ top 10 positions) has shifted to an
extreme overweight position in technology stocks (38% weighting on September 29) as these stocks have
massively outperformed in 2017. The burgeoning quantitative hedge fund category could be driving even
greater divergence in performance between stock categories. This category of funds may pose a very large if
unquantifiable market risk if and when historical correlation patterns break down.
Source: WSJ
This is not to say that passive ETFs do not have any market impact. According to Bank of America
research, individual securities with larger passive ETF ownership tend to exhibit more elevated volatility, and
small-cap index-tracking ETFs tend to have an outsized impact on the performance of the least liquid, smallest
3
These include float adjustments, relative stock weight, and cash positions among funds suffering net withdrawals, which are nontrivial but
relatively minor when viewed on a market-level scale. External fund flows can also create market-level valuation changes.
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