It doesn’t make sense to me to invest in S&P 500 (SPY) companies or other companies heavily subjected to ETF inflows, which are potentially pushed up way above their intrinsic value. Inflows into ETFs are being signaled as potentially destabilizing by a host of elite investors. They are objectively happening and there’s a very easy way to avoid becoming a victim of the latest weapons of mass destruction.

I stole the title of this piece, which is a line in the latest FPA Capital letter to shareholders where they are the latest in a long list of experienced investors including Murray Stahl, Richard Pzena, Bruce Berkowitz, Carl Icahn and Bill Ackman, that warns against the ETF phenomenon (emphasis mine):

Since 2007, $1.2 trillion disappeared from actively managed U.S. domestic equity funds and $1.4 trillion were added to passive strategies. As the number of corporate listings continues to dwindle, more and more ETFs are brought to the marketplace. This leads to more ETFs (financial vehicles), some of which use leverage, chasing fewer and fewer actual companies. Financial vehicles using leverage to purchase a shrinking pool of real assets – sound familiar?

Source: FPA letter

It’s not just active investors who observe the trend. Staff member Sumit Roy of described the data for early 2017 inflows in a colorful way (emphasis mine):

In describing the amount of money that came into ETFs during the first quarter of 2017, “enormous” would be an understatement. “Record-breaking” is technically correct, but it also doesn’t put the figure into proper context.

Instead, consider that after the first three months of last year, inflows into ETFs totaled $29.6 billion. Over the same period this year, $134.7 billion entered the space – more than four times the amount of 2016’s first quarter. If inflows continue at this torrid pace, total 2017 inflows will reach almost $540 billion, blowing past last year’s record $287.5 billion.

I’ve written previously how inflows overwhelmingly target large U.S. stocks.

Maybe I, and all these famous investors who are losing money because of the migration from active to passive, are wrong. Just, completely wrong.

There is no dislocation.

Passive is a fantastic way to cut down on costs.

That’s a possibility but consider the problem as if you have two options:

A) Invest in the ETF Universe

B) Invest outside of the ETF Universe

If you do A you’ll do fine if there is no value dislocation and everything is good. If you do A and there’s a value dislocation and these famous investors are right, you’re in for a pretty disheartening ride down or a flat market for a very long time.

If you do B and there’s no value dislocation there’s no problem. You’ll do just fine with your stock allocation exactly equal to that of an investor who chose option A.

If you do B and there is a value dislocation at some point people realize they are playing a greater fool’s game buying ETFs from each other. Subsequently they will want to get out as fast as possible. At that point you are doing great on a relative basis if you have invested outside of the ETF universe. Or schematically if you prefer:

ETF inflows are continuing on a massive scale. More and more experienced market participants are warning this trend is causing a dislocation. By investing outside of the ETF universe you can maintain the same allocation to stocks but avoid the drama if ETFs turn out to be weapons of mass destruction.

To me it’s an easy choice. I don’t own a single name in the S&P 500.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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