Goodhart's law states that "when a measure becomes a target, it ceases to be a good measure". I am starting to wonder the adage is of some application in relation to exchange-traded funds (ETFs), particularly index funds. Index funds have become massively popular in recent years, accounting for, by some estimates, as much as 35 per cent of market capitalisation on certain markets. Certainly, increased participation in financial markets is not a bad thing, and increased equity valuations due to said increased participation is not necessarily a bad thing either. I fear, however, that a bubble is forming in relation to indexed stocks.
Persons who buy ETFs are basically blindly buying a stock (actually, many stocks, but let's just focus on one stock within the fund for now) because it is indexed. A stock is indexed for various reasons, but generally it would be indexed because it is a well-capitalised company or a historically well-performing counter compared to its peers in the same sector and on the same exchange. If indexes were what they still used to be (a mere summary indicator of matters that can be otherwise researched), then there is no problem (because an investor in an indexed stock is buying a stock that has strong fundamentals that just happens to be indexed). But if the price of a stock is driven in large part ETF investors who value the stock because it is indexed, then the price of that stock becomes a feedback loop and, eventually, a bubble.
That, I fear, is what is happening with the incredible rise of "robo" fund managers and passive investment plans that seem all the rage these days, where folks simply put in a fixed amount of money that is blindly invested into the same few big name blue chips. It started out as a great idea: "don't try to beat the market, just follow the market". But now ETFs have become so commonplace that they have become the market. To use an analogy, it is like following a crowd heading to, say, an event. All goes well if one person says, ah, looks like everyone is headed this way, this must be the right way. But if everyone is thinking the same thing, suddenly everyone is following everyone else, then at some point everyone ends up in the middle of nowhere wondering, "who's leading the way?"
