Stupid Sector ETFs killed the Efficient Market Theory

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The Efficient Market Theory says that, through the wisdom of the crowd, it is impossible to “beat the market” because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information. There is something to be said for that, and perhaps it might have been right, but it isn’t today, and possibly can’t be.

The proponents of this theory tend to be those behind indexed products, such as ETFs that track an index. But they’re part of the problem. So much of the money in the investment world isn’t educated money, it is stupid money. This money comes in 401ks, IRAs, 501cs, and every other tax advantaged program that carries with it typically little selection in the realm of investment options. My own 401k has about 12 fund options. My kid’s 501c’s have I think 3 or 4 options (basic target date portfolios ranging from conservative to aggressive). This money isn’t thinking very hard about where it is going, it will match the market if stuck in a pure index fund, but if it gets into a sector based or less broad ETF it has a chance to beat the market or lag the market, and if you want to beat the market you need to be on the otherwise of the trade when they lag.

Why is this money stupid? Because index funds and sector funds are stupid in that they invest in bad companies. They also invest in good companies, but they still invest in bad companies. If you’re able to pick stocks and not invest in bad companies, you’ll beat the index. Easier said than done right?

But, sector funds are even more stupid, because they’re poorly designed.

Let us consider the tech sector. Apple, Google, Amazon, Facebook, Intel, Microsoft, IBM, and Cisco. A technology sector based ETF would include all these businesses. And SO MUCH MONEY is invested in these ETFs that these companies often trade together, but are they related, at all, to each other? Google and Facebook are advertising companies, more related to media companies than technology. Yes they each have side technology products, but the lion’s share of revenue and profits is advertising based. Apple is a consumer products company, more technology related than Facebook or Google though, they also get a lot of their revenue from the sale of music and other content. Amazon is essentially two companies, a retailer that happens to function online, and a web services company. One half of the company is fully not technology, the other half is. Microsoft is mostly technology with some offshoots (Bing for ads, x-box as a content platform and consumer product), IBM is strictly tech, and so is Cisco.

So suppose you have an investment thesis that business IT investment is going to increase, so you invest in a tech sector ETF, you’re going to end up buying a lot of stocks that have little to do with your thesis. Likewise you might think that business IT investment is going to slow, so you short a tech sector ETF, not realizing you’re also shorting ad juggernauts Facebook and Google which have little to do with business IT spending.

Energy ETFs are even worse examples of inefficiencies, and the primary motivator for my post here today. Oil prices have plummeted, energy sector ETFs are down like crazy. People either short them, or sell them, and here is the problem. Not every company in an energy sector ETF is vulnerable to the price of crude oil. In energy sector ETFs you’ll have large integrated companies (people who do everything), you’ll have upstream drillers and explorers, you’ll have downstream retailers gas stations, and you’ll have midstream pipelines and refiners. So, what are the effects of cheap oil? Will people use less oil or more oil when oil is cheap? More oil, okay, so why do you want to sell short a gas station? People are more likely to come fill up when gas is $2 a gallon than $4 a gallon? Maybe if your markup is percentage based and not flat per gallon you lose a little money, but most gas stations make their profit on foot traffic coming in and buying candy bars and cigarettes and more people filling up means more foot traffic. Will refiners lose money if oil demand increases? To the extent they have exposure to the price of oil in that they store it they might, but generally they don’t have much exposure.

Then pipelines? Pipelines are toll booth operators making money purely on the volume of traffic, not the value of the cars. Pipeline stocks went on a tear in the fracking revolution because of increased volumes, but now they’re getting hammered because of… increased volumes. It makes no sense. I’ve seen many smart people say they’re looking at pipelines right now. All these people selling or shorting energy sector funds are selling and shorting pipelines which should actually do better right now if consumers use more hydrocarbons, and with prices falling they should use more.

Of course the people who really get hammered are the drillers, and the people who supply equipment to the drillers. To the extent you can find an oil driller only ETF sure, sell that one, but a pure energy sector ETF you’ll be tossing the good out with the bad.

Another relatively stupid energy related effect of all this can be seen with solar or alt-energy stocks. Last I knew we didn’t light our homes with oil and we didn’t drive our cars with solar panels, the two industries are not heavily related, and yet they trade in tandem and have for years, that makes no sense. Then look at people like Tesla. On face value I think people will be less incentivized to buy alternative fuel cars in a world of cheap oil… BUT no one who buys a Tesla ever did it to save money. These are expensive status symbol cars, saying people buy a Tesla to save money on oil is like saying someone buys a Ferrari to save money by being able to get to work faster. The payback time on buying a Tesla versus a regular car even at $4 a gallon gas is practically forever, I’m sure Tesla’s sales will be fine with oil at $50 a barrel, and in the end this may benefit them if the cheap oil causes legacy automakers to balk at investing more in electric vehicles, allowing Tesla to get ahead even more technologically. But Tesla has been hammered lately.

In short, sector based ETFs like to pretend they’re smart by allowing you to easily focus on some thesis or idea, but in reality they’re stupid because the sectors they track are so ill defined, and identifying where they fail can lead you to investment opportunities.

Final thought: Infrastructure construction companies. Gas taxes, which are percentages, will receive less revenue in a world of $50 a gallon oil, gas taxes are almost entirely earmarked for infrastructure maintenance and construction. Politicians continually talk up the need for more infrastructure spending, but outside of any direct legislative action there will be less money this year to work on roads than in previous years, that will matter to some business out there, figure out who and you have another trade idea.

Disclosure: Long APPL, GOOG, FB, TSLA, AMZN, and lots of MLP pipelines.

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