ETFs are weird as hell. They don’t abide by the basic market precepts we were raised to hold dear – namely that in the aggregate market participants will efficiently price financial assets. Instead, ETFs tell us that one stock is just as good as another and we should just buy all of them, or at least a broad and undiscriminating cross-section. The problem comes when ETFs actually being to affect the markets they’re only meant to mirror. It’s natural to be unnerved.
But how best to express ETF-inspired dread remains a weak point for mutual fund managers and other active investors eager to shit on the competition. So we get stuff like this, from FPA Capital Fund:
“When the world decides that there is no need for fundamental research and investors can just blindly purchase index funds and ETFs without any regard to valuation, we say the time to be fearful is now,” Arik Ahitov and Dennis Bryan, who run the $789 million fund, said in an April 6 letter to investors in the actively managed fund.
It’s not just dumb valuations we can blame on ETFs. When the next big sell0ff comes, we have a culprit:
“This new market structure hasn’t been tested,” Bryan said in a telephone interview, noting that the stock market has never gone through a major downturn when passive investors were as important as they are now. “We could get an onslaught of selling.”
In other words, the unprecedented proliferation of ETFs means that we could be facing two of the oldest problems known to markets: overbuying and overselling. The money quote in the FPA letter, of course, is the contention that ETFs are “weapons of mass destruction” – which might come as more of a shock if Warren Buffett hadn’t made the exact same analogy 15 years ago about derivatives.
This isn’t to say ETFs aren’t risky. Dumb money plus complexity times leverage is always a dangerous equation. But if you’re going to panic about passive funds, you’ll have to find some better bogeymen than the two phenomena that pretty much every cycle in the history of financial markets has experienced.
At root, the ETF problem is philosophical. Recall Kant’s categorical imperative: “Act only according to that maxim by which you can at the same time will that it should become a universal law.” I.e., do stuff only if you think the world would improve if everyone did the same stuff. This concept certainly holds for taking a long position. If I’m buying up, say, KKR, it’s not just because I think everyone else should, too, but because my bet pays off only if others do the same.
But apply the categorical imperative to ETFs and things get muddled. You get Bernstein famously braying that ETFs are “worse than Marxism” because in Marxism, at the very least, you have someone doing the planning. The case for passive rests on the idea that millions of other stock pickers pick stocks better than you, so why try? But if those millions of stock…