Most Investors Don't Realize That They're Doing This

Jared Dillian |


On the grand scene of financial innovations, the exchange-traded fund was fairly innocuous at first. It took a good 15 years for people to figure out how disruptive they would ultimately be

I’d argue that the ETF revolution is less about ETFs and more about indexing; about how people have come to view stocks less as stocks and more as blobs of stocks.

(I wrote about the passive investing revolution and its implications in my free exclusive special report, Investing in the Age of the Everything Bubble, which you can download here)

After spending a career in indexes in some capacity, I am no longer much of a stock-picker. All my ideas are top-down.

I like oil. I like France. Instead of finding an oil stock or a French stock, I buy all oil stocks or all French stocks. Seems easier—what if I bought the wrong oil stock or the wrong French stock? I’m happy to take the average.

Finance is funny.

There are a lot of things in the capital markets that make sense when a few people do it, but not when everybody does it.

More Indexes Than Stocks

The thing about buying all oil companies is that you are buying the bad ones as well as the good ones—and driving all of their valuations higher.

Back in 2004 at Lehman, we observed that correlations among stocks in the same sector were increasing, at least on an intraday basis. Think about it: If oil goes up, companies like Chevron (CVX), ExxonMobil (XOM), and ConocoPhillips (COP) should all go up—on a micro, minute-by-minute basis. So, you could still make money in the long term by picking the best integrated oil major, but day trading them against each other became useless.



Fast forward to 2017, and the stock market is a sea of baskets trading against baskets. A lot of people have learned their lesson—the only thing that works is buy and hold. Which I think is a good thing!

But a lot of people still find it hard to stick to buy and hold.

Anyway, there are now more indices than stocks. Some people say this is a bit ridiculous. Well, back in the mutual fund boom, there were more mutual funds than stocks, and everything turned out fine. Is indexing causing distortions? Is it wrecking the markets?

Maybe a little. But even then, the argument is very nuanced.

The Philosophy of Indexing

The whole point of an ETF or index is that you can buy a bunch of stocks or bonds which are more or less alike or share similar characteristics. You don’t have to go to the trouble of picking individual stocks or bonds, which can be time consuming.

So let me ask you a question: Do all US stocks share similar characteristics?

Well, they are all in the US (duh) and are subject to the same political and economic forces. But that’s where it ends. You can’t get more different companies than Amazon and Newmont Mining. Or Goldman Sachs and US Steel.

So why put them all in the same basket?

I’m driving at something here—My theory is that indexing is most useful on narrowly-defined groups of stocks and less useful on the really big blobs.

The worst offenders are total market indices, EAFE, and of course, the world index. Why would anyone get long the planet? I happen to be very bearish on the planet. Cybersecurity stocks, on the other hand, make more sense.

Plowing a bunch of money into “the market” simply because it is “going up” is not smart. Just like putting all of your money in SPY is not going to cut it. Because someday, everyone will want all of their money out of SPY… at the same time.

Grab Jared Dillian’s Exclusive Special Report, Investing in the Age of the Everything Bubble

As a Wall Street veteran and former Lehman Brothers head of ETF trading, Jared Dillian has traded through two bear markets.
Now, he’s staking his reputation on a call that a downturn is coming. And soon.

In this special report, you will learn how to properly position your portfolio for the coming bloodbath. Claim your FREE copy now.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

Companies

Symbol Name Price Change % Volume
CVX Chevron Corporation 116.51 0.60 0.52 1,744,165 Trade
COP ConocoPhillips 50.47 0.25 0.50 2,288,899 Trade
XOM Exxon Mobil Corporation 81.42 0.32 0.39 3,851,283 Trade

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