Most ETFs are market capitalisation weighted, meaning they buy companies based on how big they are (their market weight). But during bubbles, it tends to be precisely the big companies that become most heavily overvalued, as investors get too excited about their growth potential.
As ETFs mostly buy big companies and do nothing to weed out overvalued stocks, they are uniquely badly positioned for the coming tech correction, the paper argued.
Entitled "Is this another diversification trap", the paper was written by Roger Montgomery, a high profile Sydney value manager. Montgomery Investments, the company he founded, sells Exchange Quoted Managed Funds (EQMFs) - a competitor product to ETFs. In making these criticisms of ETFs, Mr Montgomery joins a long list of active managers who argue ETFs are pro-cyclical.
"The ETF bubble is the transmission mechanism for a technology share bubble," Mr Montgomery wrote.
"[ETF] operators like Vanguard and State Street weight their products according to market capitalisation, and so index funds become increasingly concentrated and exposed to the largest names‚Ä¶ these names tend to be tech names, and as they outperformed the broader market, more money flowed into them, fuelling even more buying."
Evidence that tech stocks are bubbling comes from their obese PE ratios, Mr Montgomery believes. Late last year, almost half the companies in the Nasdaq - an index that is often taken as a measure of the US tech sector - had PE ratios above 200 times earnings. While the NSYE FANG+ Index (a highly concentrated large cap tech index) had a collective PE multiple three times the broad market back in February.
Like other value investors, Mr Montgomery reserves particular scorn for the chronic money-loser Netflix, which continues to have a sky-high PE ratio despite burning through cash on a junk credit rating.
Amid this tech bubble, Mr Montgomery argues, ETF investors have been sheep marching willingly to slaughter, buying obviously overvalued stocks like Netflix all the same.
"The proportion of the market's high returns that [has] been delivered by a handful of mega-cap tech stocks [is] historically unprecedented‚Ä¶ as [ETFs] grew they were forced to invest ever greater amounts in these larger companies, irrespective of price or profit outlook," he said.
"As the nine-year bull market has progressed, we have seen US index fund investors become overdependent on a hyper-narrow band of technology stocks. Today we stand on the resulting precipice."
While tech companies' valuations have cooled the past two months, Mr Montgomery argues there is still plenty of room to fall. And still plenty of stairs left for ETF investors to hit their heads on on the way down. He likens the alleged tech bubble of 2018 to the subprime mortgage crisis of 2007.
"Those who have invested in US Index ETFs, believing they are diversified, are no more protected than the municipal funds that invested in mortgage-backed CDOs and believed geographic diversification would protect them from default," he wrote.
"This is ironic given the popularity of ETFs after 2007 was fuelled by participants desiring less sector risk, less company specific or idiosyncratic risk and less manager risk."
The tech bubble will burst, Mr Montgomery speculates, as the tech giants face harsher regulatory scrutiny and investors realise that their earnings targets are unrealistic. As the bubble unwinds, value investors who have hoarded cash in recent years will be well placed to profit. He concluded:
"As the indiscriminate index investing fad unwinds, volatility will increase, and many investors will realise substantial losses. However, active, value-oriented investors with insight will be able to take advantage of a relatively rare overreaction that will set them up for another decade."
Photo: Roger Montgomery. Source: rogermontgomery.com