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ETF bubble?

Zoot Allures

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Jan 23, 2017
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Do index funds and etfs cause a bubble in the stocks they index? It seems to me money now buys an index and stocks are bought, not because of underlying value, but because they are indexed and they become overvalued whch leads to a bubble that , like all stock market bubbles, is gonna burst because of market inefficiency
 

daywalker11

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Dec 27, 2011
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Short answer is yes. ETP’s are definitely contributing towards a general bubble in the equity markets. As money is looking to find returns; especially in light of the unfunded liabilities that require yield that they can’t find in the fixed income markets, these funds are finding there way into equities. There is a severe disconnect between fundamentals and current valuations as ETF’s allocate these funds proportionally. Who knows when the bubble burst though.
 

Big Rig

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May 6, 2009
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Short answer is no. If etfs were overpricing a stock sector then active fund managers, which have far more value than passive funds like etfs, would take advantage of the situation which would bring the price back in line with underlying value

There are other reasons as well but I do not feel like explaining them
 

daywalker11

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Dec 27, 2011
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I interpreted what OP is saying as being that ETF/ETP’s are driving flows into equities belong what their fundamentals/intrinsic values would dictate.
 

Zoot Allures

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Jan 23, 2017
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I interpreted what OP is saying as being that ETF/ETP’s are driving flows into equities belong what their fundamentals/intrinsic values would dictate.
And my response is they are not

Anyways a ETF should be balanced throughout the entire market so if a sector is overpriced that means some are underpriced and you will be in on it

S&P 500 does just that
 

daywalker11

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Dec 27, 2011
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And my response is they are not

Anyways a ETF should be balanced throughout the entire market so if a sector is overpriced that means some are underpriced and you will be in on it

S&P 500 does just that
Are you considering the role that synthetic exposures in ETP’s may have in terms of liquidity? While not a major index, there was a major blow up in the VIX complex last year and this was largely created by illiquidity in the VIX ETP market. It was aptly named Volmageddon. The same thing can happen in an equity index.
 

Big Rig

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Here is what Michael Burry who was featured in ‘The Big Short’ has to say on the issue:

https://www.bloomberg.com/amp/news/...plains-why-index-funds-are-like-subprime-cdos
Interesting as he feels the same about index funds as he did the housing bubble.

He did not say he is shorting the market as he did in the housing bubble

Also, he does not say why he thinks there is a bubble.

I think there is no bubble because:

1 Most ETF trading is the buying and selling of an ETF. No additional stocks are bought during these transactions, so the mention of trillions of $ being traded in ETFs is misleadiing


2 There are more active non ETF traders than passive ETFs traders ao active traders will see distorted values caused by ETFs and sell bringing stability to market

3 The majority of stocks in index funds are actively traded not passive so they do not count. IE insurance companies employ traders to seek value stocks in order to beat the average while tracking an index. They seldom beat the average and when they do it is by luck so passive is the way to go

4 Neither of the two greatest market traders in history are alarmed and both recommend ETFs to investors. They are Warren Buffet and John Bogle. The latter created Vanguard funds which created index funds to save investors $. Unlike the all the rest of mutual fund companies, Bogle actually cared about investors above a profit.

It is so difficult to beat the market and predict the winners it seems impossible from where I see the picture

Even Buffet cannot pick a winner. He buys a cross section of value stocks that in aggregate will do well, but he has no idea which ones will be a winner, which is the definition of a quality index

You can do the same with, for example, the S&P 500. By doing so without waver, the unsophisticated investor can beat the savy professionals who are blind to even one weakness. If there is a ETF bubble that bursts stay in. If you happen to have some cash, or can save some, it will be an excellent time to buy, as it was in the housing bubble crash

The caveat is invest monies you may need in the short term in safer investments, that way you will not have to sell when the market declines. You have lost nothing until you sell.


S&P 500 has done so well since 2009 it is statistically highly improbable so expecting future performance at the same level seems foolish

But diversification is the free lunch to decrease volatility but get quality returns and while the S&P companies hold foreign companies that does not mean you get that international exposure

As well, the S&P is large cap and small caps do historically better but are hard to pick so they especially need to be indexed

Valuations are the best predictor of future outcome and the S&P P/E ratio is 20.5 while TSX is 14.6. While valuations can remain high for long times, putting all your monies into the most expensive market does not seem wise.

Remember, the market will flucuate.
 
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Big Rig

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May 6, 2009
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There are two more serious concerns with indexing and that is taxes and re balancing

What should go into a RRSP, TFSA, or non registered account for tax reasons? That is tricky enough but rebalancing your ETFs as certain stocks become overweighted makes it quite challenging

I just discovered both Vanguard and Scotia Bank offer one decision ETFs that are designed to go into any account and rebalance themselves

Your biggest decision is which one decision fund to use as some offer greater returns but that comes with greater risks, but the whole process of managing your own monies just got a lot easier

While choosing your own index funds will offer slight tax advantages, at less than .3 % for the one decision funds, the extra effort of creating your own porfolio of index funds does not seem worth it.
 
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