Why ETFs May Be Contributing To Valuation Concerns

We have seen a rapid rise in valuation multiples in recent years, with momentum trading strategies outperforming value investing, essentially since the end of the financial crisis, more than 10 years ago.

The jury appears to still be out on the direct or indirect impact of Exchange Traded Funds (ETFs) on these multiple expansions across most key sectors, but some (myself included) do believe that ETFs are indeed playing a role in driving up valuations.

My reasoning for this position is that ETFs promote blanket investing methodologies, which, by definition, are agnostic of valuation of the quality of the businesses making up a sector or index.

With increased ETF trading volumes, investor money is being put to work in a “peanut butter spread” fashion, driving overvalued companies with already high multiples to even higher levels.

This makes other companies with lower valuations seem “cheap,” though these outfits could indeed be fairly valued.

Additionally, index investing, by definition, puts ETF money into companies in proportion to their market weighting, meaning if a company grows large enough, its share price will continue to have large inflows of ETF-related buying over time, supporting the company’s share price in a similar fashion to the upward stock price pressure share buybacks cause.

My overall thesis right now is that many of the largest companies, particularly on the NASDAQ exchange, are in extremely overvalued territory due in part to the logic above.

Others may disagree with my point of view, and I’m certainly not saying ETF volume is a key driver of overvaluation, but I do think it is a contributing factor, adding fuel to the melt-up we continue to see in financial markets.

Invest wisely, my friends.