In the US, there are more equity market indices than tradable stocks. The proliferation of passive investing has seen demand for every conceivable type of index mushroom as passive ETFs are launched to cover every niche of investor demand.

Tesla, for example, appears in indices produced by MSCI, S&P, Nasdaq, FTSE, Solactive and many others. Indeed, if you buy an S&P 500 ETF today, around 2% of your money will go into Tesla, currently trading at US$850 per share with a market cap of US$800 billion, more than the next ten largest automakers combined.

If you think that is a deal you might want to avoid, how about GameStop? The most talked about stock of 2021 appears in several indices tracked by ETFs. The SPDR S&P Retail ETF normally has GameStop at a weight of around 1%. Last week it hit 20%.

The Video Game Tech ETF, GAMR, saw GameStop move from a weight of around 4% to over 27%.

It has been fun watching the Reddit crowd push the hedge fund short sellers around, but it is also a cautionary tale in the dangers of passive investing. Do you really want to buy Tesla at US$850 per share? That is what you are doing if you buy an ETF that tracks the S&P 500, the Nasdaq 100, the MSCI World, or the FTSE USA, among countless others.

You would be nuts to buy GameStop when it hit US$400+ per share. But that’s exactly what buyers of at least six ETFs exposed to GameStop were doing last week.

That is because passive funds are price takers. They track a specific index and when you invest in that fund, you are investing into every stock in the index at whatever the prevailing price and weight is. They have no discretion to avoid obvious bubbles.

Equity indices were originally designed to measure the market. They follow a set of rules about which stocks are represented (most often market cap weighted) and then measure the returns of that portfolio.

However passive funds have now grown to over 40% of the US equity market and this is now influencing the way the market works.

Tesla’s stock rose over 22% between the announcement that it would join the S&P 500 and its entry into the index. As passive inflows into funds tracking that index continue, they are constantly buying into Tesla and supporting its current stratospheric valuation.

GameStop is not as broadly tracked as Tesla but buying an ETF with GameStop as a constituent would be a brave investment decision.

This is where active managers have a distinct advantage. An active portfolio is run by a human, not a spreadsheet. If #WallStreetBets targets a stock in an active portfolio and pushes its price far beyond any rational level, an active manager can simply sell it and take profit. The index fund cannot and is obliged to buy even more if they receive inflows.

As I discussed on Ausbiz yesterday, the bottom line is that passive investing is often perceived as a safe, diversified way to get exposure to the equity market. But if the index a fund is tracking is exposed to a bubble such as GameStop, then caveat emptor. 

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