Yesterday I wrote about how the YOLO memesters might be creating market inefficiencies, today I thought I’d look at the other side of the coin with the more mature, more upscale passive ETFs.

For those who don’t know, a passive ETF is just a pile of money that you can buy into like a stock. When you hold a stock of $VTI for example, you own a tiny percentage of that big pile of money. The money in turn isn’t just a bunch of cash, it’s invested into the stock market according to the ETF’s prospectus, from which the ETF is not allowed to deviate from by law. $VTI’s prospectus says for example that it will seek to track the performance of the whole US stock market by investing in a representative sample of companies in that market. In this way, $VTI isn’t making a decision on the worth or value of any individual stock, it is merely buying every stock and assuming the market will do the hard work. Since the value of the total US stock market grows at an average rate of between 5% and 10% every year (with some down years like 2022), this means that $VTI is expected to grow at that pace as well and an investor in $VTI can make 5% to 10% returns without any of the stress or hassle of picking their own stocks. The only things $VTI asks for in return is a tiny amount of money in the form of it’s expense ratio, just 3¢ for every 100$ of investor’s money is taken for expenses, which seems to be a reasonable deal for everyone involved.

$VTI and other ETFs like it are easy, low-risk investment vehicles, so it’s no wonder they have exploded in popularity. Not only that, but studies have demonstrated that passively managed ETFs almost always outperform their actively managed peers. But is this “$VTI and chill” mindset of investors creating market inefficiencies of its own? Remember that passive ETFs invest in the whole market, regardless of if an underlying stock is any good or not. Not all ETFs are as broad as $VTI of course, some seek to track a certain market segment or a certain type of stock, but all passive ETFs share a commitment to obeying their prospectus and investing in valid companies without precondition. This means that they cannot participate in price discovery which is seen by some as the primary purpose of markets, including stock markets. If company A is growing, profitable, and well run, then it should be rewarded with having a higher value than it’s competitor, company B which is shrinking, unprofitable, and poorly run. We would expect that the stock market would perform price discovery on these two companies, investors would buy stock in the A and sell the stock in company B, raising and lowering their stock prices in turn. This then rewards company A for its success, and lets it use its high stock price as a tool to further expand the company, hopefully rewarding investors in the process and creating a virtuous cycle of success breeding success.

But passive ETFs don’t participate in price discovery, they don’t sell bad companies and buy good ones. Passive ETFs buy a representative sample of companies according to their prospectus, and they keep their expense ratios as low as possible in part by not doing the kind of deep dive on their investments that you would expect from an active investor. If company A and B are both worth 5% of the total stock in a passive ETF’s market, then it will hold 5% of its total value in both A and B. And if every investor in the market was a passive ETF, then there would be no way for the price of A and B to move relative to each other, because there would be no sell pressure on one relative to the other. Indeed some have claimed that the rise of passive ETFs is making the market less efficient, and tipping the scales towards large companies that will get bought up by the most popular ETFs simply because they are large and thus make up such a large portion of the market. If this is the case, then the erudite bogleheads are doing as much damage as the memesters.