ETFs Revisited + Make Some Money With Rewards
All the "Buy $VOO and Chill" posts are tickling my contrarian bone
I had a conversation with a family member, lets call them Bohn, that inspired this free post. It went something like this.
Bohn: “O man you see NVIDIA is on a tear”
Fer: Yea, they have a nice market demand with chips and servers and [thesis on the name]
Bohn: “Yea, well I didn’t know all, but I want to get those returns so I bought some SP500 ETF since they are in it. SP is already up 20% this year so I am going to crush it.”
Fer: Wait…when did you buy the SP?
Bohn: This morning so my return this year is going to be awesome
(Yes, Bohn thought buying the SP in May meant he would get the full year return come 12/31).
With the stock markets have been running and hitting all time highs. This brings out the parade of ‘Buy ETF and chill’ people. There has been a plethora of posts about how you can’t beat the market and just need to keep buying into large cap, known, ETFs. But it is easy to forget a lot of people don’t understand even the basics, they just see sentiments like:
Buy VOO 0.00%↑ and get diversification
Buy QQQ 0.00%↑ and get growth
SP500 has returned 12% year-to-date, why do any work, just buy it.
On and on and on
There is nothing wrong with the strategy of passively investing in ETFs. If you are just starting out, it is a great way to get exposure to stocks with your little bit of savings. If you are focusing on making more money (you should be, most likely) and don’t want to be bothered doing market research, then yes - buy an ETF. If you really really really don’t like the market, then it is easy to do. Or if you are focused on other areas of investment (Real estate, crypto, your own business) and a small amount of your net worth is in stocks relative the other areas, by all means, ETFs are good diversification from your main net worth.
Heck, for people starting out on their financial journey, I even recommend ETFs as the way to start in equity markets. It is what I wrote in my ebook (Get your copy of Zero To Some here):
But for all the positives of the well known ETFs (low fee, tax-efficient, exposure to a lot of stocks for 1 price, etc), they aren’t always the only answer.
This will be the 2nd time I take on ETFs in the stack. The first time I went over 10 little talked about issues with ETFs.
Just Buy ETFs Right?...Right?
Just buy ETFs. You get diversification, its passive, and you match the market returns and no one outperforms an index benchmark. This advice is everywhere. Heck, it is the advice on what you should invest in while trying to fix your financial situation in
This time, we will get a little more pointed and really focus on 1 aspect of the ETF that many people miss that could be steering your wrong and leading to performance drag.
Again - if you really don’t like investing, if you don’t have a lot of money to invest, if you have the majority of your net worth in other investments, or if you are focusing on making more money - then just buying an ETF while you figure out the rest of your finances is probably a good move.
But, if you are like many people out there, you probably have a 401k that is limited to ETFs and already buying shares every 2 weeks or so. Therefore, you may be doubling and tripling down on the risk of ETFs by doing the same in your personal account.
So what is the big issue with ETFs we are going to focus on in this post?
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Buying High and Selling Low
This is not what you want to do. Buying stocks that are ‘over-valued is a recipe for suboptimal returns.
But ETFs are typically always constructed in a way that new money is buying lots of highly valued stocks and ignoring lower valued stocks.
[Note - Yes, there is an investment strategy of ‘buying winners’ and following momentum. And this strategy can be successful.]
Let’s dive in.
Market-Cap Weighted Indices
Most of the well known ETFs track market-cap indices. The S&P500, Nasdaq, etc are all given a weight by market cap. What does this mean?
Market capitalization is simply, the total dollars of equity out there for a company. It is calculated by taking the outstanding shares multiplied by the price of a share (there is some adjustments that can be made to outstanding shares based on what is freely tradeable, but lets ignore it for now).
If a company has 100 shares available at $100 each, it has a $10,000 market cap. If another company has 10 shares available at $1,000 each, it also has a $10,000 market cap. (This is why the price of a share doesn’t matter and stock splits don’t impact performance. You need to look at the market cap).
Basically, if the equity value of a company is $10,000, you can split it as many ways as you want - 10 shares for $1k each, 100 shares for $100 each, 1,000 shares for $10 each, 10,000 shares for $1 each, 100,000 shares for $0.10 each, etc etc.
For our purpose here, when a stock price goes up the company’s market cap goes up. A stock with 100 shares trading at $100 has a $10,000 market cap. If share price doubles it now has a $20,0000 market cap ($200 price x 100 shares = $20k). A company with a $20k market cap will have twice as large of an allocation in the index as it did at $10k market cap, all else equal.
So if a stock doubles, and you buy an ETF, you are getting a larger allocation to that stock AFTER its price has doubled.
Let’s pretend the value of the company (which is unknowable, but put on our omnipotent cap here and assume we know what the value of the company should be) is $15k market cap. You would want to own much more of it when it is at $10k than you do at $20k. If you really knew it was absolutely worth $15k, you would actually want to go all in at $10k when it is undervalued by 50% and own 0% at $20k when it is overvalued by 25%.
However in ETFs, it is the opposite way. You buy less when the stock is undervalued since it has a lower market cap and buy more when it is overvalued since it has a higher market cap.
And we see this play out in real life.
Knowing nothing at all about this stock other than seeing this chart, what would you think:
Year-to-date this stock is up over 130%. And in the last month it has popped hard. Would you look at this stock and say “I want to own twice as much at $1100 per share as I did at $500”?
Maybe. If you are a momentum guy or trend follower, but most people would see a more than doubling in a stock in 5 months as likely meaning most of the ‘easy return’ has been wrung out.
What if I told you this stock had almost a $3 Trillion market cap and a price-to-earnings ratio of almost 100 (meaning it earned $11 a share - or it would take 100 years at its current earnings to earn it’s share price.). That is a large company with a lot of continued growth baked in. If a typical growth company has a P/E of 30, that means that this company is valued like it is growing 3x as fast as a normal growth company.
Just based on the chart, you would likely want to own twice as much at $500 and less at $1,100. Most people take gains on big moves or try to prevent positions from getting too large.
For example, if you had a 10% allocation to this stock at $500 and it went to $1,100, all else equal you would have over a 20% position in the name now. That is a big concentrated bet on a single name.
Well, this stock is Nvidia (no opinion on the company). And if you compare the SP500 ETF allocation to Nvidia on 1/1 vs 5/24 you would see:
The take away. A $100 contribution today gives you almost twice as large of an exposure to NVIDIA vs $100 contribution at beginning of the year.
Fly Wheels - Example
Let’s say you put $100 into the SP500 today, and get a 6% allocation to NVIDIA. What if the stock isn’t really worth $1,100? What if the $600 it was worth at the beginning of the year is where the market decides the real value is?
Clearly, you lose 50% on your NVIDIA position.
But we can go a step further. As the price of NVIDIA drops, each bi-weekly 401k contribution into the SP500 will go less and less to NVIDIA. Remember, every dollar going into these ETFs, that make up most peoples 401k investment options, is allocated based on the then current index. So if a stock is getting 6% of 401k flows today, and only 3% of flows tomorrow, that is less buying support for the name.
As more and more people go to using ETFs, that leaves less active investors. These are the marginal buyers who suddenly have an outsized impact on the stocks.
This can be seen easier with an extreme thought example. Imagine tomorrow Congress passes a law that EVERYONE can only invest in ETFs. That is it. No one can buy individual stocks. Let’s even go a step further and say only in the SP500 ETF. What happens? The weights of the ETF will never change. Every dollar invested will go in and buy x% of a stock based on its current weight in the ETF. It doesn’t matter if Microsoft, NVIDIA, Berkshire, Apple, etc start losing massive amounts of money. If you want to invest, you need to buy an ETF which will buy the same stock allocation.
Basically the stocks relative weights are locked in forever. The SP500 may go up or down, but the return of each stock will exactly match the SP500 return so the weights never change.
Now, knowing how Congress works, lets say there is a small carve out on page 69,420 that allows Nancy Pelosi to choose individual stocks.
Nancy gets insider info…err…is a shrewd investor and therefore will buy, sell, and short stocks based on laws Congress is passing.
In this world, Nancy has full control of the weights in the index. If Nancy buys up a bunch of NVIDIA, then she single-handedly adjusts how the weight in the SP up. And if later she sells a bunch, she single-handedly adjusts it down.
In this extreme example, it is clear that the marginal non-ETF buyer is driving the weights in the index. But in real life, as passive ETF investing becomes more and more popular, you have a smaller group of buyers doing the same thing.
Wrap-up
This post is in no way meant to say ‘don’t buy ETFs’. For a vast majority of people, it is an easy way to get exposure to equities with minimal effort. And going a step further, most people don’t even know how to evaluate a stock and make good investment decisions.
But, it is important to know what you are buying and how it works.
There isn’t a great and simple solution to this “buying stocks after they move up bigly” issue:
You could buy SP500 and short the names that you think are over valued, but if those names continue to be strong, you will lose your shirt on the short positions
You could look at alternative indices - Equal weighted SP500 that puts a flat % in each name, a value index or growth index, small cap index (Russell 2000), etc - but each of those have their own risks
Equal-weight ETFs are smaller and less known, but an interesting concept
You can invest in individual names - this at least lets you sell a stock that your purchased that doubled, but it is hard to get broad market exposure and requires you researching and forming opinions on companies
In summary, buying passive ETFs can get you some exposure and diversification (although with 10 stocks making up 1/3 of the weight, 50ish stocks making up 2/3s and 250 stocks only making up 10%, it isn’t as diversified as many people think).
But its important to understand new money is always buying more of the stocks that have gone up recently and less of those that haven’t. And there is a chance this leads to buying more over valued names before they correct and less under valued ones. Recent history has seen the big names continue to get bigger, but that may not always be the case.
Now you can make a more informed decision.
Good Luck Anon.