What are ETFs?
It stands for "Exchange Traded Funds". These are automated funds that operate electronically with no manual oversight.
How do they work?
Investors can purchase a share in an ETF on a brokerage just like any other stock. They are not necessarily buying the stock from another investor. If more people want to buy ETF shares than are being sold by existing investors, then they are "purchasing" it from the company that runs the ETF. What they actually do is issue you a share in the ETF, then use the funds you provided to purchase other assets that the ETF is supposed to represent.
If more people want to sell their ETF shares than people are buying, then the ETF provider will have to sell the underlying assets in order to have enough cash to repurchase the shares from the investor.
What does the ETF represent?
Often it is used to "track" an "index". This is why they are often called "index funds". And index is simply something like the S&P 500 - which represents the value of the largest 500 companies in the US. Or the FTSE 100 - the largest 100 companies in the UK. The algorithm is setup in such a way that the value of the ETF should roughly match the value of the underlying assets. So spending $1000 on ETF shares should get you a representative share of the 100 largest companies in the UK by market capitalisation. I.e. if the largest UK company is 10% of the market, then $100 of your $1000 is spent on that company. If the next largest company is 9% of the market, then $90 of your $1000 is used to buy shares in that.
Note that if the companies that form the index change relative value, then the ETF will automatically "re-balance".
So let's say the two companies above had their share prices change. The first company grew in size to be 12% of the market, and the second one shrunk to become 8% of the market.
The ETF would then be forced to sell shares in the second company to purchase more shares in the first one.
Why do people invest in them?
Do to being fully-automated, they typically have much lower fees than "actively managed" funds (i.e. funds that are run by humans doing analysis and making decisions).
How well do they perform?
Apparently very well! In fact it's very difficult to out-perform a passive ETF through your own analysis and making your own investment decisions.
The drawbacks
One major drawback of an ETF is the fact it is blindly purchasing the underlying assets regardless of the price. Normally if things become more expensive then their higher price would tend to put other people off buying. Unless of course it is getting genuinely better and more valuable.
But an ETF will just buy more shares if there are net money flows into the fund. It has to, and it will buy at whatever the market price is. This has the potential to drive the price up further, which then inflates the asset values, which then forces the ETF to purchase more of these stocks. It has that potential to create a self-fulfilling prophecy, whereby companies are valued highly because they are included in an ETF and not due to underlying business fundamentals.
Are valuations too high?
So are the assets the ETF is buying getting genuinely more valuable?
In my opinion, the value of a stock has to eventually boil down to dividend payments. An investment has to eventually pay you cash in order to be a legitimate investment. Otherwise you are relying on the investment strategy of "Finding a bigger idiot".
Sure you can make capital gains, but that's only really valid if the underlying asset has gone up in genuine value (and not based on speculation or simply the fact it has previously gone up in value).
So to justify higher valuations, you have to believe that the stock will one day pay a larger dividend than we previously thought. So if I think it was going to pay $5 a year per share, then maybe I value it at $100 per share. If I believe however than in 2 years time it will be paying $10 per share I might value it closer to $200 per share. This could then drive the stock price up.
There's no doubt that companies like Apple, Facebook and NVIDIA are solid companies with good earnings. They obviously provide a lot of value to society and make a lot of sales. However there are 2 key metrics which I think cast doubt on whether these companies are overpriced or not.
High P/E ratios
The price to earnings ratio essentially tells you how much you pay for a share compared to the profit that share generates. In other words, a P/E of 1 says that you could purchase the entire company for the same amount as their annual profits.
A P/E ratio of 10 means you would have to pay 10 times the company's profits that year to purchase the stock.
Many of the top US companies (which dominate the S&P 500), trade a P/E ratios of 30-40. So this means if you bought that company, you'd have to wait nearly half a century to get your money back.
You can justify high P/E ratios if you think earnings are going to increase in the future. But to bring these companies into line with other investments, they would need to nearly quadruple their profits in the near future. Why take on all that risk when you can simply buy a company that is already trading at a more sensible P/E ratio?
There is another issue at hand
Low dividend yields
These companies people will argue are "growth stocks", and what you are buying now is not what they will be in 10 years time. This maybe true, but you only have to look at the poor dividend yields to see an issue with that. They are typically well below 1%.
So while the company is making profits, they are not returning those profits back to investors. That's because they have to constantly spend billions on R&D to create new products. These are intensively competitive industries.
And when you see a company like Meta spend tens of billions on the Metaverse only to find out that nobody actually wants that, you have to wonder if they are taking good care of investor capital or if they are just spunking it on vanity projects or burning it up competing with each other for market share.
Compare that to a company like Coca Cola, which is selling the same product they made 100 years ago, and probably using bottling plants that are decades old you can see the issues with an investment like NVIDIA.
Capital Growth
But the S&P has out-performed many existing investments over the past decades. So it doesn't matter if you have low dividend yields because you are making that money in equity growth.
Right?
Well only if at some point in the future these things do actually pay out high dividends. But history would suggest they are not going to do that (haven't done for decades) and just thinking about the nature of the industry you wonder if they'll ever be able to afford to do that.
So again, we are potentially relying on the "Find a bigger idiot" strategy, and that equity growth is going to come simply because there has been equity growth in the past. And we are into trading sardines territory, or tulip mania, where people are buying only in the hope it goes up in price so they can hand it off to someone else.
This is speculation not investing.
Negative Consequences
There are issues with a few large companies dominating the stock market with massive valuations. It generally allows them to access cheap capital, either through issuing new shares (which sell for a handsome price), or by borrowing money and using company stock as collateral.
This then gives them an advantage over smaller companies who have to borrow money at higher interest rates, or raise equity at worse valuations. We should question if this is actually good for the economy and consumers long-term if only a few large corporations have a competitive edge when it comes to financing.
Also if these large companies all have the same shareholders - i.e. the ETFs, it does decrease the incentive for competition. Why would I want all 4 of the major social network companies I own to be wasting billions of my profits competing with each other?
Other factors
It's possible that other factors feed into higher prices for stocks. If stocks generally are becoming a more popular investment, then the laws of supply and demand might dictate that you have to accept lower yields in the stock market.
There could also be fundamental shifts in the economy which mean the old laws don't apply any more.
I'm somewhat skeptical of these arguments but I'm also not arrogant enough to write them off completely.
What does the end look like
We have to realise that basically while there are net capital flows INTO the ETF market, ETFs will continue to buy up these stocks regardless of the price.
But we can imagine scenarios where eventually, people don't simply enjoy owning Apple stocks or the S&P 500. We might imagine, that they eventually want to buy something with that money. Since these stocks are paying very little dividends, they will be forced to basically sell their shares in the ETF so they can go on holiday, or buy a new car.
This happens all the time of course, but the question is - what happens when this is happening more than the flows of capital into the ETF market? Inward capital flows are limited basically by people's salaries. They have to be earning surplus cash in order to purchase the shares. Sure they can borrow money, but borrowing is also limited by earnings.
When there are net capital flows OUT of the ETF market, then ETFs will simply start selling these shares - again regardless of the price.
If this starts to mean that ETFs don't perform very well, then this could prompt a cascade of capital flows out of the ETFs. Even if people don't choose to sell their shares, if NVIDIA or Apple valuations drop, then the ETF will be forced to re-balance the portfolio and sell the shares anyway.
It's not hard to imagine scenarios where the entire market collapses and people lose a lot of money.
If you look at any historic stock charts you will notice the down is always much faster and steeper than the ups.
What am I doing about it?
It's a difficult one. Because being too pessimistic means you could miss out on a decade of massive growth. The crash could be a long way into the future, and if you'd refused to invest in the S&P 500 ten years ago you'd be left with egg on your face now.
My approach right now is to put part of my portfolio into ETFs, but not put all my eggs in one basket.
I also try and purchase good dividend yielding stocks, as well as other traditional assets like property and bonds.
I'm also hedging my portfolio by investing in alternative asset classes that are not subject to the normal business cycle.