Steven Bregman on the Problem With ETFs and Crypto

Notes on Steven Bregman's presentation at the 2018 East Coast IDEAS Conference

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May 22, 2018
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Steven Bregman of Horizon Kinetics was a 2018 East Coast IDEAS conference speaker. Horizon Kinetics is a thought leader within asset management within at least two subjects: the problems of the ETF industry and cryptocurrency.

Bregman spoke about two subjects, and you can listen to the entire hour-long call here. The full slide deck can be found here.

To save you some time, I’ve taken notes and will provide some context where I can.

Bregman began his remarks by telling active investorsit’s not their fault.

Many active managers are performing poorly currently.

He showed a slide with a number of established active value managers who have fared poorly in recent years:


The slide is almost all gurus like

Bruce Berkowitz (Trades, Portfolio), David Winters (Trades, Portfolio), Mario Gabelli (Trades, Portfolio), Mason Hawkins (Trades, Portfolio), Warren Buffett (Trades, Portfolio), Bill Ackman (Trades, Portfolio), Carl Icahn (Trades, Portfolio), David Einhorn (Trades, Portfolio) (I just wrote about this) and Chuck Royce (Trades, Portfolio).

These investors are all doing badly, even though they are running different portfolios, are of different generations and use different techniques and approaches.

All underperformed while beign star managers.

Either they are the anomaly or they are not.

If they are not, the market is the anomaly.

How indexation is causing it

On a deeper level it is all due to the indexation trend.

One would be hard pressed to find two value stocks in theS&P 500.

The market's overvaluation in two charts:


Quoted from Bregman's slides:

"The Yield Crisis Forces Money Into Higher Risk Choices

For the first time in over 50 years, stock and bond yields have converged. Artificially low interest rates are pushing money toward yield at any cost – yet, it comes at a cost. If the exclusive focus is on the yield benchmark, that obscures other valuation measures, and one does not see that a 3% yield on a REIT index is really equivalent to 1/0.03, or a P/E of 33x. The one seems reasonable to the desperate; the other seems foolhardy to the objective."

Today's bubble is delivered by ETFs

The market has distorted clearing prices in all sorts of assets.

Indexation is not the root cause.

That is the business end of it: the ETF industry.

The ETF industry is causing massive systemic risk, with distortions by formulaic, basket-like investing.

This has created a bifurcated market in the ETF divide.

It distorted not just prices but the price discovery mechanism.

A valuation sobriety test

Bregman showed a number of different fixed income products and asked the audience to guess the yield


You can try it yourself by guessing the yield-to-maturity for the above products.


The yields on these fixed-income products (which means valuations) do not make sense

There is no analyst concerned with this. There is no price discovery.

Then what is this ETF really worth?

Take the lesson from this bond index and apply it to the equity indexes. The same thing is going on with equity indexes; it is just harder to show.

Magnitude of the problem

We’ve seen a $4 trillion swing from active to indexing.

Indexing is OK, but the ETF business is not.

Indexing is not the problem. The problem is the ETF business.

The vision of indexation was to own the entire market, not what’s going on with the ETF industry.

Vanguard is a not a for-profit institution, and it is offering indexes at cost. The for-profit companies can’t compete with Vanguard. Now the business of ETFs must be done at scale.

The indexation ruleset is tinkered with to make sure ETFs can scale.

There is also a need for product differentiation to be able to charge higher fees.

Bregman showed a slide of some ETFs to demonstrate how they market one thing but it consists of something else.


Investors in an Energy ETF may not realize it is concentrated 50% in just four positions.

Investors may not realize their Spain ETF has its top 10 positions derive 70% of revenue from outside of Spain.

Liquid stocks that performed well are included in a lot of different ETFs.

Why the S&P 500 is overvalued

"Low interest rates justify the high valuations in the S&P 500" is a common argument. But it doesn’t work because historically the constituents were growth companies.

In 2016 the S&P 500 revenue growth was 4% but without FANG stocks it was negative.

Enormous effort is expended to find low volatilty sectors with sufficient liquidity as building blocks for ETFs.

Collapse in fees caused a lot of exotic ETFs.

But a new ETF needs to backtest well.

Statistics like beta are employed for asset gathering.

Price-earnings ratios are not always what you think they are.

The Swiss central bank holds $93 billion of U.S. stock (2,600 stocks)

Active management is now competing with governments who have access to “unlimited” capital.

Diversifying to achieve safety no longer works (the basket nature of ETFs makes everything trade in tandem).

What to do in this ETF world?

There are plenty of ways to buy a reasonable bond or instrument.

The mainstream ways just aren’t that way.

Maybe indexation flows don’t stop?

It is pretty clear that the flow of funds into passive is being fueled by the bank of active management.

It is only a certain number of years before that bank starts running dry.

When the index buying stops, the automatic bid for a number of stocks will disappear, as the marginal buyer will be the active manager.

Indexation has about a 37% market share.

The methodological flaw in ETF's definition of float is that its recursive.

Where to invest instead of ETFs?

Investing now must take place outside of the indexation sphere of focus and away from systemic risk.

You can do it within the system and away from the ETF vortex.

Or you can go outside the system inside something that may cause one of the greatest wealth transfers in history.

If indexation starts to reallocate to small caps, that doesn’t work.

You need fewer securities but of a more idiosyncratic nature.

Useful search variable: liquidity

If you can take some liquidity risk, your options expand tremendously.

Investment example No. 1

Norway doesn’t attract much inflow because it is a very small percentage of ETFs.

Shipping is a very small sliver of ETFs.

Subsea 7 (

SUBC, Financial)

  • Does underwater engineering work?
  • 37% lower revenues than in 2012.
  • Shares 40% lower than in 2012.
  • Owner/operated company.
  • Repurchased lots of shares.
  • Acquiring related business.
  • 6x trailing cash flow.
  • No risk of the company going out of business.
  • Perpetual free call option on the recovery of oil.
  • Offshore renewable business that didn’t exist a few years ago.

Stock like this could triple.

Can’t find things like this in the ETF indexes.

How should asset allocation take place?

Indexation is not going away (it is here to stay).

Allocators in the future after a sufficient period of unsatisfying results may seek out active managers.

Those active managers won’t be compared to the benchmark but judged on some absolute basis.

Indexes will be the base, but there will be no place for index huggers.

Ultimate non-systemic asset class (cryptocurrency)

1. Succes mode

If bitcoin gains market acceptance as a parallel currency, it can easily still go 1000x.

If that return seems outlandish, it shouldn’t because you’ve all seen it before.

How many times your money would you have made if you bought Microsoft at the IPO or anywhere in the first year?


Not that many people owned a PC in 1993.

That was a study of a product going from minimal market penetration to dominance.

You can think of bitcoin in the same way.

from 1944 to 2017, the U.S. dollar also lost 93% of its purchasing power.


2. Debunking bear arguments

Bitcoin isn't useful for doing groceries.

Bitcoin is very divisible -- you can make any small purchase easily.

The bubble argument

There is a study showing there are 16.5 million millionaires in the world.

Interestingly, at the time of the study there were approximately 16.5 million bitcoins as well.

What if only millionaires want it? And they all want only one coin?

A lot can go wrong with bitcoin, but it’s not in a bubble.

To be in a bubble everyone needs to hold it, but no one is holding it.


There is a bubble in cryptocurrencies

Most of them don’t have a non-inflationary policy.

The only thing that’s valuable about bitcoin is that’s the first non-dilutable currency.

Government suppression

Japan altered its banking laws to legalize bitcoin.

Bitcoin futures have been established.

In December the CME and CBOE futures were green lighted.

The Arizona senate approved taxes to be paid via bitcoin.

FED posted white papers and tutorials and simplified excerpts.

Scaling and transaction processing speed

Woefully inadequate at the end of last years.

For months now, there has been an upgrade bitcoin lightning network.

It has been tested with real commercial transactions.

There have been 40,000 transactions per second of the VISA network are matched.

This is a disruptive threat.

Price volatility

There are futures now.

This is going to dampen volatility as the future markets get deep enough.

With futures retailers can easily accept crypto.

Walmart pays 3% fees on transactions to credit card companies.

That’s 60% of its margins.

Amazon pays $6 billion in credit card fees.

These can be virtually eliminated.

Disclosure: Author is short SPY.

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