The Dark Side of ETFs – The ETF P/E Magic Trick

Published on
August 19th, 2017
Micro, Liquidity, ETF
42 minutes
Asset class
Equities, Bonds/Rates/Credit

The Dark Side of ETFs – The ETF P/E Magic Trick

The Interview ·
Featuring Steven Bregman

Published on: August 19th, 2017 • Duration: 42 minutes • Asset Class: Equities, Bonds/Rates/Credit • Topic: Micro, Liquidity, ETF

Steven Bregman of Horizon Kinetics explains to Grant Williams that all is not what it seems in the ETF Market, in the first part of this incredible three-part interview. As you appreciate the magic tricks employed to reduce PE ratios and influence sector diversification, you begin to understand that investors are getting something diametrically different to what they expect. Filmed on June 29, 2017, in New York


  • HU
    Henry U.
    19 August 2017 @ 12:07
    Great way to start a Saturday morning, Excited for what's coming next.
  • SB
    S. B.
    19 August 2017 @ 12:14
    Unfortunately, sometimes ETF's are the only viable option for consumers to invest in certain markets. Buying individual companies in for example Emerging Markets or even Frontier markets is very difficult or almost impossible for an individual investor. The other problem is a number of separate stocks you end up with to diversify. Keeping track of each stock is a lot of work, and almost impossible for a non-professional investor, so diversifying in a sector to mitigate risk is the next-best solution. Actively managed funds are less liquid and it is frequently hard to judge which one will outperform.
    • SA
      Scott A.
      19 August 2017 @ 16:40
      But the point is you probably are not mitigating risk, at least not the way you think. If I buy "tech", I think I'm buying Silicon Valley, Israeli startups, and Asian robotics software companies, not Amazon, Apple and Netflix.
    • SB
      S. B.
      19 August 2017 @ 17:06
      For western tech, it's not really a problem. Then you should probably buy individual companies. But for Emerging Markets and Frontier markets, I would not know how to get exposure without using ETF's. Managed funds are also not always very transparent because of large performance differences. I also don't like the exposure of EM ETF's (20-30%) to the Financial industry. This can sometimes be good of course, but also a negative. I would rather invest mainly in the local consumer sectors in booming EM markets with young populations. I just don't know what products/funds to use.
  • CR
    Charlie R.
    19 August 2017 @ 14:06
    Excellent in-depth discussion! Way to go Grant/Raoul/RV team! The elemental build of Bregman's preso is so instructive! RV partnership sub is best investment I made recently!
  • BL
    Barclay L.
    19 August 2017 @ 15:19
    Very best yet for Realvision. The market etf vortex of combined consensual craziness is very real. Wealth destruction to follow.
  • MW
    Matthew W.
    19 August 2017 @ 15:44
    Grant - the story you were trying to think of at the beginning is Druckenmiller
  • SA
    Scott A.
    19 August 2017 @ 16:40
    Great interview. A true eye opener.
  • WM
    Will M.
    19 August 2017 @ 16:51
    Ok my interest is really peaked ,,,,, great
  • JE
    Jos E.
    19 August 2017 @ 19:31
    The bit about EMHY was genuinely mindblowing
  • SS
    Sam S.
    19 August 2017 @ 19:53
    What's an ETF? Ha, just kidding----however----what's being discussed here is exactly that-----what is it really? Mind blowing facts. Please give us the "safe play" to CYA so when the blowup happens, money has to go somewhere. Love the comments that he doesn't listen to financial news anymore------really---not even RV TV? I get it and agree. Learned helplessness.
  • PB
    Pieter B.
    19 August 2017 @ 20:35
    My hat off to both of you! Brilliant!
  • MO
    Mike O.
    19 August 2017 @ 20:59
    Yowie ... I think I get the big picture (and it doesn't look good). Unfortunately (for me), I knew almost nothing about the financial markets until the last couple of years (e.g., what is an EBITDA; how about IRR; what does contango, backwardation mean, etc. ... all sorts of terms that I've had to try and learn and understand as I see them in articles). The PE stuff here had me scratching my head a bit as I was trying to follow (although I got the concept). In my own defense, I only had a 401K with funds in it to invest in ... why did I NEED to know any of this stuff (since I was fully occupied with the demands of a career that took all of the energy that I had to keep up). I literally have to THANK YOU so much RealVision TV for the opportunity of a knowledge transfer that you are providing (there's a pretty big hole to fill in my head) ... I only hope it's not too late to be of help.
  • BF
    Bruce F.
    19 August 2017 @ 22:44
  • JH
    Jesse H.
    20 August 2017 @ 00:29
    Fantastic - and inspiring that Bregman had the guts (and integrity) to walk away from what he knew was an unethical product offering. The magic trick of P/E's and the (incredibly) distorted rates on the Russian, Lebanese and Petrobras bond allocations are disturbing. In some ways, this feels like the CDO crisis (magic trick) all over again, but taken to new heights.
  • JH
    Jesse H.
    20 August 2017 @ 00:34
    As an engineer, I can say with a reasonable degree of confidence that harmonic means and weighted means are appropriate in the physical world when dealing with electricity, forces, etc. I have not the faintest idea why one would use a harmonic mean for financial products - these types of means apply to wave distortions associated with AC electricity, not financial products. And using the average of the reciprocals, instead of the straight average, is confusing (27 vs. 20 P/E). Would be interested to hear their technical argument (of Vanguard, for example) for such an approach. My BS alarm is going off.
    • KG
      Kevin G.
      20 August 2017 @ 01:38
      Having just thought this through myself, I actually think that the harmonic mean would be the appropriate way to calculate the P/E of an index. For example, take the four stocks that Steve mentions in the video (P/E of 50, 10, 20, 30), and imagine that 1/4 of the index is invested in each company. I think the most logical way that people would think about an index P/E would be tied to this question - "how much in earnings would a dollar invested in the index get me?" So the 50 P/E stock with a 25% weight gets you $0.005 in earnings for that dollar invested, and so forth. When you add up the earnings that you get from the four stocks, you end up getting $0.0508333 for your dollar invested in the index. This means that the index P/E is 1/0.0508333= ~19.7x, not 27.5x (which is the average of the four P/Es).
    • JH
      Jesse H.
      21 August 2017 @ 22:48
      Interesting point, Kevin. Will give this some more thought. I think this is a weighted mean calc not Harmonc mean...but that is based on recollection of engineering math from many years ago. Will have another look.
  • DH
    Daniel H.
    20 August 2017 @ 00:44
  • MR
    Marten R.
    20 August 2017 @ 02:11
    ETF acronym challenge... Everyone Totally Fooled ? (I can think of another F word which would be equally appropriate...) Grant - great work. Steve - brilliant. Incentives matter. Low fees require mega scale in a equity world where that is not all that easy to find. So, the game is rigged. Definitions matter. Exchange Traded Fund does not mean Indexation. (but seriously - PE... does not mean PE? that's next level stuff.. bravo Wall Street... Joe 6 pack get your magnifying glass out and read that fine print... DEVIL... is in that detail). The upshot of all this is... our necks are all in the ever constricting and eventually suffocating noose of - Financial Repression. Ye shall not escape. The very foundation of price discovery in fiat money is the interest rate. As that is corrupted, so everything else eventually goes. In the new era of central bank dislocation (as opposed to coordination)... watch out. Liquidity shock/risk are rising to 'Red Alert' levels. Most objective analysis points to overvaluation. In everything and everywhere (the everything bubble)... Be overweight cash. Thoroughly analyse what's in your portfolio and if you wouldn't buy it at todays prices.. lighten up or sell completely. Stay disciplined and remember rule number 1. MR
  • PC
    Pedro C.
    20 August 2017 @ 14:11
    This is a great interview! Brilliant!
  • RJ
    Robert J.
    20 August 2017 @ 16:29
    Pearls before the swine!
  • BL
    Bruce L.
    20 August 2017 @ 20:57
    Brilliant. ( and Grant it was Druckenmuller's boss you were thinking of)
    • TM
      Terry M.
      24 August 2017 @ 14:55
      Yep, google "Stanley Druckenmiller speech Lost Tree Club"
    • TM
      Terry M.
      24 August 2017 @ 14:55
      Yep, google "Stanley Druckenmiller speech Lost Tree Club"
  • AC
    Andrew C.
    21 August 2017 @ 02:28
    At the 25mins left mark and still lots to go; But the reason why he left his employer investment bank is exactly why ETFs are popular today. Retail investors are sick of getting ripped off with conflicted advice. The "2
  • AC
    Andrew C.
    21 August 2017 @ 02:56
    At the 25mins left mark and still lots to go; But the reason why he left his employer investment bank is exactly why ETFs are popular today. Retail investors are sick of getting ripped off with conflicted advice. The 2 and 20 fee model with underperforming advisors is the very reason.
  • RH
    Robert H.
    21 August 2017 @ 13:14
  • GS
    Gordon S.
    21 August 2017 @ 16:40
    Quote from the interview: "[Lebanese] GDP numbers have not been published for years. They can't get it together. The most recent GDP numbers I saw I think were from 2008. And I looked on the website of the US Embassy and I looked at the format. It looked familiar to me. Then I went to see CIA Factbook. I think they just came directly from the CIA Factbook." I was interested in that affirmation since a friend of mine is Lebanese. I tried googling a little but found no quick evidence. Has someone any article to recommend on that fact? Thanks!
  • RA
    Robert A.
    21 August 2017 @ 21:33
    Amen Brother, Amen.
  • ZH
    Zack H.
    22 August 2017 @ 00:15
    Mind blowingšŸ˜³ 2007 will be a dress rehersal for the real event when all this comes to an end.
  • DT
    Dmitry T.
    22 August 2017 @ 15:41
    Very interesting stuff. However, personally I would love to see more detailed description of how funds are created, how money goes in/out, who decides if asset composition has to change and how often, etc. The fact that some stocks are mis priced is in itself an opportunity. When market dislocates, it is time to explore how to profit from it. Can we hear more views or some tradable ideas? On a negative note, discussion regarding EM bond ETF is completely misleading. Yes, there is a liquid $ Russian Sovereign 2030 maturity bond which trades at 2+% yield. (it is sinking fund so this bond is under 7 years duration, hence low yield). Plus it is owned by Russians, hence trades tight. And other mentioned bonds are also tradable. And relevant debt statistics are available for discussed countries. iShares J.P. Morgan USD Emerging Markets Bond ETF is a well capitalised fund which provides exposure to 30+ countries. So please check your information, otherwise you confuse people.
    • PA
      Pascal A.
      23 August 2017 @ 13:36
      Totally agree with you Dimitry. Not only the duration is altered by the sinkable feature but also the credit risk. A better comparison would be using the 4.25% $ 10y Russian Government Bond which trades at arround 4% yield.
  • CM
    Cory M.
    22 August 2017 @ 19:20
    The last 2 minutes made me nauseous. Equally brilliant as it was terrifying.
  • SC
    Sean C.
    23 August 2017 @ 01:21
    Just shows you no matter how great an interview is, there are still down votes. I don't get it. I thought it was brilliant.
  • SP
    S P.
    23 August 2017 @ 02:21
    This is a very enlightening discussion. ETFs and passive investing have certainly been taken too far. Thank you for this interview. It certainly is misleading for the ETFs to omit companies with negative earnings and those with very large PEs. But isn't the weighted harmonic mean the correct way to estimate the PE of the index? Let's assume you had 1000 dollars to invest in an index of 4 stocks A,B, C and D with market caps 100 billion, 50 billion, 30 billion and 20 billion dollars each. Assume their respective earnings of 1, 2, 3 and 5 billion respectively (in other words, PE of 100, 25, 10 and 4 respectively). Your $1000 would be split this way: $500 worth of stock A, $250 of B, $150 of C and $100 of D. The $500 of A will entitle you to $5 of the earnings. Similarly B will fetch you $10, C will fetch you $15 and D will get you $25. Your $1000 entitles you to $55 of earnings in total. This is an effective PE of 18.18x. This is the weighted average harmonic PE. In other words, one needs to find the weighted average earnings yield and find its inverse to get the index PE. The weighted average PE in this example is 58.15 and simple average is 34.75. But we earn much more than 1000/58.15 = 17.2 dollars as shown above. What a high simple average or weighted average PE really tells us is that there are some very high PE stocks in the index (such as Amazon in QQQ) which pull the averages up. It doesn't tell you what earnings you are entitled to.
  • ii
    ida i.
    24 August 2017 @ 15:45
    could you explain the following? I went on bloomberg to check out this harmonic P/E for the QQQ ETF, ad infact it is indicated at round 22 like on the factsheet which states that it is a Harmonic PE. However I checked the data for the Nasdaq 100 index, and it is the same. the PE for the nasdaq composite is 38 almost 39. Does this mean that even the PE of the index is a Harmonic P/E? so indexes like the nasdaq100 is created for the ETF industry? I hope you can clarify, thanks
  • VP
    Vincent P.
    24 August 2017 @ 18:38
    Just great!
  • CC
    Charnes C.
    24 August 2017 @ 21:25
    Not spamming. Just getting the word out. I'm trying to wrap my head around markets, cycles and how they relate to each other. I created a website to connect with others in the investing community. I am not selling anything and simply want to throw my ideas "out there" for critic / comment. As a practicing physician, no one around me seems the least bit interested in markets, debt, cycles, money, gold, etc. Thanks in advance.
  • RT
    Richard T.
    26 August 2017 @ 04:23
    I am sorry but this guy is way off. Someone has already pointed out that the correct way to calculate the P/E of a portfolio is to invert the P/Es, average and reinvert. How does he not know this? Secondly on the EMB, as pointed out Russia trades much higher in yld and his comments about liquidity are just uninformed. The EMB mkt cap is USD 11bn. I do not have data other than the top 10 holdings but the 10th concerntration is 0.70% so USD77mm. This is the Argent 7.5 2026s which is a USD6.5bn issue. So if someone came into sell 10% of the outstanding EMB ETF (a very high figure) it would require the sale of 7.7mm of the Argent 7.5s. Just tiny. The Lebanon issue is likely no more than 0.25-0.3% of the portfolio so getting a bid would similarly not be a problem. Not impressed.
    • ii
      ida i.
      26 August 2017 @ 13:18
      In fact I found this in a textbook for the CIIA exam : The weighted harmonic mean is the preferable method for averaging multiples, such as the priceā€“earnings ratio (P/E), in which price is in the numerator. If these ratios are averaged using a weighted arithmetic mean (a common error), high data points are given greater weights than low data points. The weighted harmonic mean, on the other hand, gives equal weight to each data point.[ The simple weighted arithmetic mean when applied to non-price normalized ratios such as the P/E is biased upwards and cannot be numerically justified, since it is based on equalized earnings; just as vehicles speeds cannot be averaged for a roundtrip journey. For example, consider two firms, one with a market capitalization of $150 billion and earnings of $5 billion (P/E of 30) and one with a market capitalization of $1 billion and earnings of $1 million (P/E of 1000). Consider an index made of the two stocks, with 30% invested in the first and 70% invested in the second. We want to calculate the P/E ratio of this index. Using the weighted arithmetic mean (incorrect): {\displaystyle P/E=0.3*30+0.7*1000=709} Using the weighted harmonic mean (correct): {\displaystyle P/E={\frac {0.3+0.7}{0.3/30+0.7/1000}}\approx 93.46} Thus, the correct P/E of 93.46 of this index can only be found using the weighted harmonic mean, while the weighted arithmetic mean will significantly overestimate it.
    • ii
      ida i.
      26 August 2017 @ 13:22
      Mr. Williams please help us understand. I agree that there is a passive investing bubble and the firms create ETFs are losing control, but I really am not convinced about this PE thing. Of course if you want to state that the common investor cannot understand what harmonic PE is, I agree on that, but bloomberg uses harmonic PE to calculate the PE of many indexes so active funds probably use it too. So I would have preferred an analysis explaining why nobody should use harmonic PE, it is not just the ETFs that are using it. Please answer, thank you.
  • RT
    Richard T.
    28 August 2017 @ 05:51
    To follow up my earlier post, I now have the holdings data for the EMB. It comprises 104 corporates and 273 sovs. Lebanon has 9 issues included totalling USD337mm and 2.85% of the EMB mkt cap. Ave daily turnover by value of the EMB is 266mm needing a daily Lebanon trade of 7.5mm to hedge/disaggregate (assuming all one way). Highest EMB amt this year was June 1 at 818mm requiring a Lebanon trade of 23mm spread across the 9 issues = 2.6 per issue. None of the issues is smaller than 1bn and the largest 2bn. These are tiny amts relatively. There is no trace data on these issues but I warrant that daily volumes are many multiples of EMB requirements and the tail is not wagging the dog.
  • MC
    M C.
    29 August 2017 @ 15:13
    Unfortuantely some fundamental flaws with his logic - although I do appreciate listening to differing view points. Let's address the bond liquidity. With respect to EM, i doubt there are many credible retail portfolio manager that would advocate individual EM bonds for a client portoflio, The ETF provides a very efficient technology to achieve exposure to a broad based, diversified portfolio of bonds - even those with bonds from Lebanon. With repect to the Lebanese bonds he specifically mentions, while i have no idea on the specifics of the ETF he is referring to what I can opinine on is that, generally, no fixed income ETF is 100% replicated. The underlying index it tracks probably is contructed from 1000s of issues. The ETF's physical portfolio will obviously be an optimized replication of that index such that it will generally own only a sufficient quantity of bonds to minimize tracking error to the index. Therefore the % he mentions of Lebanese bonds may not be physically held by the ETF. But regardless of specific issuers (Lebanon, Russia, Brasil etc), the objective is the risk profile of EM debt as part of a diversifed portfolio with hopefully other uncorrelated asset class to provide better risk adjusted returns. Also, these are not stand alone allocations. An EM bond ETF, IF appropriate for a client portfolio, may only represent a small % of the overall assets. This idea that passive is a bubble is just too simplistic. The conversation, again, is not passive vs. active - but COST. Active aboslutely has a place in portfolios but not a 2/20, 1/10 or at traditional mutual fund pricing. Also, well constructed passive ETF indices by tier 1 asset managers are being used as efficient exposures in active portoflios.
  • CS
    Chris S.
    8 September 2017 @ 08:59
    The index PE 'problem' is not new and has not been caused by ETFs. Actually, different data providers have had different methods of calculating index earnings / PEs for decades. It's an index problem not an ETF problem. I find the overall discussion about the 'passive bubble' a little overdone and too general. Not all passive is bad and not all ETFs are passive.
  • ct
    constantine t.
    8 September 2017 @ 11:23
    CIA factbook figures on Lebanon are perfectly up-to-date
  • AK
    Anton K.
    10 September 2017 @ 10:01
    Best interview ive seen on Real Vision so far in H2. If managers are not spending some performance on buying catastrophe insurance heading into Q4 and 2018 theyre not doing their job and should be fired. Valuation dislocations in asset prices due to ETF fund flows are now pretty damn scary and he does a great job of providing factual evidence of this. The analysis on EM Corporate Bond Spreads over bench is insane! I'll be doing a lot of work on hedging out EM downside risk in my portfolios on this. THANKS RV!
  • JM
    James M.
    11 September 2017 @ 14:22
    Great interview and who couldn't agree with what the fellas saying. But what the fuck does it matter, his first mistake is thinking like a rational logical money manager. We all know the whole thing as is a joke there is no market and there isn't likely to be until we get complete and utter collapse of the whole thing, which when that happens we will have bigger worries developing than 401ks. Obviously the only game in town is the Japanese QE infinite as explained by Jeremy Granthum in 2009 , where those ETFs come in really hand to buy up the whole stock and bond market oooops market mmmmmm dont think we have had one of them for a while if ever. Whats the fukin point of trying to think logically about all this shit and shorting it? The JCB have manged to keep this lala train goin for over 3 decades and its clear thats the plan form the FED, ECB, BOE etc etc. But I appreciate the guys time anyway. BTFD lol
  • TB
    Tad B.
    15 September 2017 @ 22:53
    I'm loving this. Frightening... but a must watch. This guy is great ! He should be looking after our dosh :) Market Cap weighted ETFs are a given; we all know how to spot those....... where 5 companies represent 30% of a fund comprised of 500. BUT, the PE calculations ARE UNREAL !!!!! Seriously ?! Buyer beware on the exotic junk rubbish but, the TRICKS to LIE being uncovered here are fascinating.
  • JD
    Joe D.
    2 October 2017 @ 22:48
    Very key ideas at the very end.
  • JT
    Jayne T.
    20 October 2017 @ 16:38
    Hey Steve, excellent presentation and good to see you again -- I worked with you guys at BT.
  • RD
    Ryan D.
    8 July 2018 @ 03:32
    Iā€™ve watched this series at least four times and will no doubt watch it again. I think this and Michael Greenā€™s ā€œGreat Rotationā€ are the most important presentations for retail investors (like myself) to really understand. Many thanks for sharing; I have no doubt that this information will save me money over the course of my investing career.

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