A Bloomberg News article caught my attention last week. It cited the managers of FPA Capital Fund Inc., an actively managed equity fund, making the following assertion in their quarterly letter to investors: “Exchange-traded funds are ‘weapons of mass destruction’ that have distorted stock prices and created the potential for a market selloff.”
Although I believe that statement not only is problematic but also wrong, I decided to download and read the complete missive of co-managers Arik Ahitov and Dennis Bryan. They say lots of interesting things, and dissecting what the managers of this $789 million fund wrote is our charge today.
No. 1: Fundamentals no longer matter
Let’s assume the assumption is true; the key question is, “Does it matter?”
First, there have been many forms of stock analysis where the fundamentals are not relevant and haven’t been for a long time: momentum investors for starters care little about fundamentals; the same for technical analysis. Pure quantitative research may or may not use fundamental inputs. These are all substantial schools of analysis, and they support billions or even trillions of dollars in investments.
Second, smart beta—also known as fundamental indexing—has been one of the fastest-growing areas of indexing and ETF creation. It has captured more than a half-trillion dollars in assets. Using fundamentals to create indexes instead of market-capitalization weighting demonstrates that fundamentals are critical to many indexers. To suggest otherwise requires you to ignore $500 billion in smart beta investments.
No. 2: Valuations are too high
As we observed last week, trying to judge whether a market is overvalued is a fool’s errand. Pricey stocks can and do get pricier, often for years. If your strategy is to wait for prices to decline to where you think they should be before buying, the market might very well outlast your patience.
No. 3: ETFs will cause trouble during selloffs
We don’t need to hypothesize about what might happen during a market dislocation. We have a real life experience to use as our base case: The 2008-09 financial crisis.
The experiences of two of the larger index-fund companies, Vanguard Group Inc. and Dimensional Fund Advisors LP, are fairly instructive. Almost all of their account holders sat tight during the selloff. Most of the panic was located was in other parts of the financial system.
No. 4: Too much margin debt
We have discussed this several times before, but let’s remind readers: Margin debt isn’t a leading indicator, nor does it indicate that markets are overpriced. It rises as stocks rise; it falls as stocks fall. For more on this, see our earlier discussion on New York Stock Exchange margin debt, “A Market Indicator That Predicts Nothing.”
No. 5: Index membership
The argument here seems to be that inclusion in an index supports the prices of stocks that otherwise would or should fall. This feels like it makes intuitive sense, but it’s wrong.