Passive Investing Bubble

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The markets are way up. Should I avoid both indexed and active managed ETFs right now? My investment style is long-term, high and moderate risk.

 

Cody Shirk, Surfer, Capitalist, Contrarian, Traveler, Entrepreneur, Investor codyshirk.com

Answered Jul 23

 

Yes. You should be very careful.

(Great question, by the way! This is the “Passive Investing Bubble” that many are worried about.)

Most arenÂ’t considering the risks that accompany index funds and ETFs.

In fact, most people think that those two investment vehicles have no risk.

Just like the housing market didnÂ’t have any risk in 2006Â…

LetÂ’s take a look at the largest ETFs:

Source: ETFdb

IÂ’ll pick the largest ETF, $SPY, as an example.

$SPY is by far the largest ETF with almost double the assets under management than $IVV, the next largest.

So what is $SPY? What equities does the ETF hold?

WellÂ… thatÂ’s easy to find out. Here are the top ten holdings:

Source: SPDRS

Looks good, right?

A fairly balanced mix, with no huge allocations to one company.

That means the ETF is completely protected from a market crashÂ… because itÂ’s so diversifiedÂ… right?

WRONG.

Do you know what happened during the housing crash?

Basically, the crappy home loans of thousands of homes were spread out among many securities… hence the name “Mortgage Backed Securities.”

But not many people were worried because these crappy mortgages (that people might not pay back) were spread out. So, even if a bunch defaulted, then it wouldnÂ’t effect anything.

Well, we all know what happened.

BUT THIS SCENARIO IS TOTALLY DIFFERENT! (I can hear you saying that!)

Well, thatÂ’s kind of true.

We donÂ’t have a bunch of toxic mortgages floating around our financial system.

But, we do have A TON of money investing in passive investing vehicles like ETFs and index funds.

“This concern is rooted in the very nature of passive funds: They buy stocks without considering the fundamentals.” Source: LATimes

And guess what those ETFs and index funds are buying?

They are buying the top companies in our stock market, which are expensive by a variety of measures.

So the ETF and index fund you may be invested is definitely diversifiedÂ… but itÂ’s diversified among a bunch of expensive companies!

BUT THATÂ’S NOT THE MAJOR PROBLEMÂ…

The problem here is liquidity.

Liquidity is a word I know we will all be hearing more about.

If you are an experienced stock trader, then you should be very familiar with liquidity.

Basically, liquidity is the ability to buy and sell an equityÂ… or really anything.

YouÂ’ve got to have buyers and sellers to make a market work.

What will happen when those equities in those ETFs and index funds start to lose value?

People will start selling. And then more people will sell. And then more.

Pretty soon there will be large numbers of people who want to sell and there will be no BUYERS.

ThatÂ’s because all the buyers have either lost their money from the falling ETF and index fund prices OR they are the major funds who have seen this scenario unfold from a mile away.

(TheyÂ’re just waiting for everything to fall, so they can pick up the pieces.)

There are 2 arguments to the above:

#1 This is all wrong, and I donÂ’t know what IÂ’m talking about.

Answer: Maybe. LetÂ’s see what unfolds in the near future.

#2 It doesnÂ’t matter when you buy an index fund, because you hold it over the long runÂ… market fluctuations donÂ’t matter in the bigger picture.

Answer: True. But, IÂ’d much rather buy when things are cheap and ride the wave up than buy when things are expensive and wait years to get back to where I started.

***ItÂ’s important to note that not all index funds or ETFs are at risk right now. For example, $URA is a uranium ETF. Uranium is trading at historical lows with not much room for a major price fall.

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70%—The probability of a stock market correction per Vanguard Group. That’s about 30% higher than the average over the last 60 years. But what does Vanguard know? It only manages $5 trillion in assets...