EFTs Are Legal Ponzi Schemes

The first US-listed ETF was the SPDR S&P 500 ETF Trust (SPY), launched in 1993 by State Street Global Advisors. It tracks the S&P 500 Index and remains one of the largest and most actively traded ETFs today. ETFs sound like a great idea because they could mimic any index while eliminating the numerous commissions necessary to do so. But this nice idea has proliferated into a multi-headed monster, and there are now almost as many ETFs as publicly traded companies in the USA. I can’t even get my head around this and what it means and how it ends.   

Let’s be clear: There is no doubt that ETFs have been a fabulous wealth creator, and I’m not saying or expecting any investor to just dump ETFs and start stock-picking or move into mutual funds. However, it is important to at least get educated on the effect that ETFs have had on a process some call “Price Discovery”, the ability of a stock to find its natural and fair price level based on available public information. In fact, ETFs have pretty much eliminated true price discovery.  

How did this happen? There are today about 5 or 6 ETFs that are tied to the Dow Jones Industrial Average. Nothing too over the top there. And the Dow likely has its own “crash protection team” in place anyway, whoever and wherever they may be. But let’s pick out a couple of top tier industrial names like Emerson Electric (EMR) and Honeywell (HON). They are invariably going to be in the portfolio of any new industrial ETF that is formed, and there are a lot more than 6, and counting.

Regardless of the exact number, here’s the point, if oversimplified. If Emerson or Honeywell comes out with an earnings miss, the stock perhaps goes down a per cent or so, while in the old days it might have been 10-15%. I remember making some money on a Procter & Gamble short 25 years ago when the stock plunged from $87 to $61 in one day; this doesn’t really happen anymore to big important household name stocks. By the time the ETF portfolio “managers” can meet to discuss a possible sale of Emerson or Honeywell stock, another ETF has been formed and is buying, because they have to, because they are great names with great industrial businesses. Next thing you know, the stocks reverse an initial decline, no one is selling because the stock is up on negative news, and there goes your so-called price discovery. In addition, these fine companies can carry on making acquisitions with their “unnaturally” elevated stock prices.  So again, wonderful wealth creators they have been, so liquid and Bernie Madoff worry-free,  but investors should at least understand that most stocks underlying ETFs are inherently overvalued.