A Practical Reason to be Aware of ETF Activity

In investing, it is important to understand what industries the companies in which you invest are in.  There are several reasons for this:

  • Companies within an industry tend to face the same cost pressures.
  • Companies within an industry tend to face the same revenue drivers.
  • Companies within an industry tend to face the same regulators and political pressures.
  • Companies within an industry tend to face the same behavior from debt-financers and equity investors.

Now, some companies have competitive advantages that are difficult to replicate, but those are not plentiful.  It is no surprise then that equity performance within industries tends to be tightly correlated.

Now consider ETF activity.  The largest ETFs cover whole stock markets, or sectors containing many industries.  The trading can drive the prices of many stocks regardless of the fundamentals in the short run.  The ETFs allow for simple decisions to be made.  “Financials stink; sell the XLF.”  “Technology stinks; sell the XLK.”  “Energy and materials will do well here, buy the XLE and XLB.”

The thing is, in each of those sectors, there is a lot of variation.  Is there a reason to worry about financial companies that focus on mortgages?  Yes.  Does that have anything to do with insurers?  Aside from mortgage, financial and title insurers, no, it doesn’t.  What do chemicals have to do with base metals?  Not much.  Do refiners and E&P companies benefit similarly from a rise in the price of oil?  No, it is the opposite; one buys oil, the other sells.

ETF trading activity can be a benefit to the fundamental investor.  When your companies come under pressure from ETFs because ETF holders sell indiscriminately and the company that you own is not a party to the macro phenomenon that is leading to the selling, it is time to buy a little more.  When your companies rise because ETF buyers buy indiscriminately and the company that you own is not a party to the macro phenomenon that is leading to the buying, it is time to sell a little.

ETFs simplify decision-making for many investors.  Sophisticated investors will avoid the simplification and drill down the economics and the industries and companies that they own, leading to greater profits in the long run.