If the next crash is ETF-based you can’t say you haven’t been warned. After Murray Stahl (Trades, Portfolio), Bill Ackman (Trades, Portfolio), Berkowitz is now also warning these vehicles for all their worth come with drawbacks.
On CNBC Berkowitz talked about index investing. It’s a great solution if you don’t get spooked, you don’t invest at a time the index is at an extreme valuation or when interest rates are at a historic low. If and when interest rates go up that’s a “gravitational pull on all assets.”
Berkowitz portfolio contains several companies that aren’t well represented in indexes at all like St. Joe’s, Sears and many Sears related companies and Fanny and Freddie preferred stock.
As the famous contrarian makes huge concentrated bets a crash in stocks that are well represented within ETFs would do wonders for his relative performance.
Theoretically a great tool, the ETF accelerated indexation from inception at a very rapid pace. The Financial Times had Morningstar compile a report and it showed passive funds now accounted for a third of all mutual fund assets. Active funds have seen their market share decline since 2013.
The flow of money does appear to have an effect on valuations in the market. As Murray Stahl (Trades, Portfolio) opined in the FRMO Corp annual letter(emphasis mine):
As a consequence of the industrial scale upon which indexes operate, the largest companies frequently have valuations far in excess of smaller companies. For example, large-capitalization shares have outperformed micro-capitalization equities for years. The S&P 500 trades at nearly two times the price-to-book-value ratio of a typical micro-capitalization index. This is very unusual.
However, the enormous industrial scale of indexation investing, as well as the market capitalization float adjusted methodology of weighting, requires maximum trading liquidity that simply cannot be provided by genuinely small companies.
Bill Ackman (Trades, Portfolio) also had a thing or two to say about the trend in his early 2016 letter(emphasis mine):
We believe that it is axiomatic that while capital flows will drive market values in the short term, valuations will drive market values over the long term. As a result, large and growing inflows to index funds, coupled with their market-cap driven allocation policies, drive index component valuations upwards and reduce their potential long-term rates of return. As the most popular index funds’ constituent companies become overvalued, these funds long-term rates of returns will likely decline, reducing investor appeal and increasing capital outflows. When capital flows reverse, index fund returns will likely decline, reducing investor interest, further increasing capital outflows, and so on. While we would not yet describe the current phenomenon as an index fund bubble, it shares similar characteristics with other market bubbles.
The migration towards index based investing distorting valuations as Berkowitz, Ackman and Stahl warn makes a lot of sense to me and consequently I own only two S&P 500 stocks and very few that are heavily represented among indexes. It seems like the perfect time to scour Guru portfolio’s for idiosyncratic holdings that aren’t fit for ETF inclusion.
To leave you with a Berkowitz quote:
You know it will badly fail at some point.
Disclosure: Long FRMO
