Q&A – Inefficient Markets

Do ETFs distort market efficiencies?

You gave a great overview of ETFs and S&P yesterday that was really helpful. This article that I am linking talks about some inefficiencies that are being created by money flowing into ETFs and most people avoiding active investments. As per the article, this pattern is creating inefficiencies that can be exploited.

What are your thoughts on this?

Answer

I believe markets are inefficient. Actually, I know this to be the case. This is why there is a difference between the Price of a share (amount at which it was last purchased and sold) and the Value of the same share (the present value of all future free cash flow of that share of the business).

It is likely true that market inefficiencies will increase as ownership of passive index funds rise. However, as I’ve argued, most actively managed mutual funds are “closet indexes” that tend to have portfolio holdings mirroring an index anyway. Thus, much of the herd is already following the index. Nevertheless, I believe you are right in thinking that markets may become even more inefficient in the future.

It is absolutely true that market inefficiencies can be exploited by smart investment managers who:

  1. Can identify large discrepancies between the price and value of securities; and
  2. Have the conviction to purchase such securities when they’re “on sale” (i.e., when the rest of the market underappreciate them …. often for a very long time – much longer than many investors can tolerate).

Such managers (the most famous being Warren Buffet) typically do not manage mutual funds (which are constrained by the short-term measurements that plague the industry). Rather, these managers often work for large pension funds or private companies or funds owned by high net worth investors or family estates.

Large misalignment of price vs. value of a company’s stock can also be exploited by the company itself. That’s why many companies (e.g., Apple, Google, McDonalds, etc.) often buy back their own shares (when company management thinks its shares are priced well below their own opinion of its value). At times, this can be the best way for a company to allocate its own capital. It’s also an efficient way to return value back to its shareholders.

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