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You shouldn't worry about ETFs and index funds being in a bubble per se. ETFs are structured out of holdings of other stocks. There are built-in mechanisms that

You shouldn't worry about ETFs and index funds being in a bubble per se. ETFs are structured out of holdings of other stocks. There are built-in mechanisms that keep their price in line with these other stocks: specifically, if the price diverges, it becomes profitable for the big traders and the like to buy other stocks and turn them into shares of the ETF, or vice versa. Provisions exist for doing this, so for a widely-traded ETF, the market will therefore be pretty efficient and the ETF itself will be priced fairly relative to its constituent stocks. (For a thinly traded no-name ETF, this may not be as true, however, and the prices may diverge - but we're still taking a few percent rather than, like, ten percent.) So worry about a bubble in the stocks the ETF holds, instead. Unlike ETF-to-stock drift, that isn't something that day traders can fix: only big-time active investors, hedge funds and the like with billions in assets and insane risk tolerance who are seeking market-beating returns, can actually trade enough volume to move the price on big stocks like that, and if big-time passive institutional investors (like masses of individuals armed with ETFs, or pension funds, who are not in it to beat the market) happen to be too irrationally exuberant about stocks, the hedge funds may find it too risky or not profitable enough to trade enough that it corrects the stock price back to what that price should be. But if you believe in a bubble in those stocks in general, you'll probably have to look beyond big names like AAPL and 3M that are already in your index fund, and you'll be back spending hours a day doing that beat-the-market research.

tlrobinson 9y ago
I think the parent comment was suggesting stocks could be a in a bubble due to the popularity of ETFs/index funds.
- pedrocr 9y ago
  That can only be the case if people are moving money from other assets into stocks because of index funds. Maybe that's happening (less CDs perhaps?) but the argument for indexing is much more "stop buying expensive managed stock funds and use much cheaper stock index funds". And that shouldn't create a bubble in stocks because there is no more capital invested in total.
- exelius 9y ago
  Equity bubbles are nothing new. I do think we're in a bit of a bubble (not a huge one, but the market is overvalued right now IMO) but again, the market is cyclical and I expect we'll enter bear market territory again soon. But on the other side of every equity bubble are hedge funds looking to short sell the crap out of everything. Once those guys start making money again, we'll know the bubble has burst. Also, 10-year T-bills still exist if you're afraid of an equity bubble. Returns are historically bad, but they've always been used as more of a safe haven to stash money during a downturn than anything else. The fed is raising rates again, which will likely end up cooling off the equity market.
- cko 9y ago
  Yes, that was one concern. pedrocr's reply below (in addition to all the other comments) makes sense - if the current inflow in passive funds is just active funds being sold and reallocated, doesn't seem too bubbly. Though I am an active reader in the early retirement / Financial Independence blogosphere, and the real life people I talk to (usually nerds) are like 'Vanguard or gtfo'. So it would seem like the average person, and especially Baby Boomers looking for 'safe returns', would think "well, everyone's recommending it so it's all good" and voila, hundreds of billions flowing in. On the other hand my coworkers, most of whom wont read a book to save their lives, are just happy there is employer matching on their 401Ks. I suspect that's more representative of the average population. Not sure the data on this. Also, would the share price of these passive funds go up due to demand enough to cut significantly into returns? Like a 30% increase in share price just because everyone is jumping on the bandwagon takes a while to make up for. (Am I wrong? How much exuberance would it take to bubble up an ETF's share price significantly?) Thanks for all the replies, though. I'm looking for both sides of the argument. The businessinsider article supporting the 'bubble view' was a quick read but too light on substance.
  - wbl 9y ago
    ETF arbitrage pins them to the basket they hold pretty well.
  - fennecfoxen 9y ago
    > Also, would the share price of these passive funds go up due to demand enough to cut significantly into returns? Like a 30% increase in share price just because everyone is jumping on the bandwagon takes a while to make up for. You can look up ETF-price-to-asset-price ratios. For example: https://finance.yahoo.com/quote/IVV https://finance.yahoo.com/quote/IVV Right now the price is listed as $245.48 and the NAV is $243. That's a 1% difference and honestly I wouldn't be surprised if some of that is Yahoo's NAV price estimate being stale because someone has automated the conversion of the price difference into free money using computers. Probably multiple someones.

tlrobinson 9y ago

I think the parent comment was suggesting stocks could be a in a bubble due to the popularity of ETFs/index funds.

pedrocr 9y ago
That can only be the case if people are moving money from other assets into stocks because of index funds. Maybe that's happening (less CDs perhaps?) but the argument for indexing is much more "stop buying expensive managed stock funds and use much cheaper stock index funds". And that shouldn't create a bubble in stocks because there is no more capital invested in total.
exelius 9y ago
Equity bubbles are nothing new. I do think we're in a bit of a bubble (not a huge one, but the market is overvalued right now IMO) but again, the market is cyclical and I expect we'll enter bear market territory again soon. But on the other side of every equity bubble are hedge funds looking to short sell the crap out of everything. Once those guys start making money again, we'll know the bubble has burst. Also, 10-year T-bills still exist if you're afraid of an equity bubble. Returns are historically bad, but they've always been used as more of a safe haven to stash money during a downturn than anything else. The fed is raising rates again, which will likely end up cooling off the equity market.
cko 9y ago
Yes, that was one concern. pedrocr's reply below (in addition to all the other comments) makes sense - if the current inflow in passive funds is just active funds being sold and reallocated, doesn't seem too bubbly. Though I am an active reader in the early retirement / Financial Independence blogosphere, and the real life people I talk to (usually nerds) are like 'Vanguard or gtfo'. So it would seem like the average person, and especially Baby Boomers looking for 'safe returns', would think "well, everyone's recommending it so it's all good" and voila, hundreds of billions flowing in. On the other hand my coworkers, most of whom wont read a book to save their lives, are just happy there is employer matching on their 401Ks. I suspect that's more representative of the average population. Not sure the data on this. Also, would the share price of these passive funds go up due to demand enough to cut significantly into returns? Like a 30% increase in share price just because everyone is jumping on the bandwagon takes a while to make up for. (Am I wrong? How much exuberance would it take to bubble up an ETF's share price significantly?) Thanks for all the replies, though. I'm looking for both sides of the argument. The businessinsider article supporting the 'bubble view' was a quick read but too light on substance.
- wbl 9y ago
  ETF arbitrage pins them to the basket they hold pretty well.
- fennecfoxen 9y ago
  > Also, would the share price of these passive funds go up due to demand enough to cut significantly into returns? Like a 30% increase in share price just because everyone is jumping on the bandwagon takes a while to make up for. You can look up ETF-price-to-asset-price ratios. For example: https://finance.yahoo.com/quote/IVV https://finance.yahoo.com/quote/IVV Right now the price is listed as $245.48 and the NAV is $243. That's a 1% difference and honestly I wouldn't be surprised if some of that is Yahoo's NAV price estimate being stale because someone has automated the conversion of the price difference into free money using computers. Probably multiple someones.