The Invisible Octopus

[This article appears in our June 2018 issue of ETF Report.]

Even when using indexes, our investment decisions have an impact on the market.

Adam Smith’s invocation of the “invisible hand” has probably generated more discussion than any topic in economics. While often used as a shorthand for “market forces,” the point Smith makes in his seminal work, “Wealth of Nations,” often gets lost. His argument at its core is that people acting in their own self-interest are “led by an ‘invisible hand’ to promote an end which was no part of his intention.”

I would argue that the rise of factor and smart-beta investing is actually proving Adam Smith’s point in unexpected ways, and the “end” in this case is the actual functioning of the market.

Depending on how you count, more than half of the ETF market offers exposure to a factor in some form. After all, the original Fama/French factors are small-minus-big (market cap) and high-minus-low (book-to-market, or value). Investors have so absorbed these original factors into their thinking that I doubt many would describe their investment in an S&P 500 ETF as their “large-cap bet,” even though it absolutely is.

Factors Everywhere

Taken as a whole, the ETF market is dominated by these factor bets. By my count, only eight funds (roughly $20 billion) out of the 1,477 equity ETFs are truly generic global market bets. Taken as a whole, the decisions we make as investors to be in anything but those few funds—decisions we all make seeing profit—actually serves an incredibly important purpose: price discovery.

ETF and indexing naysayers are hung up on price discovery. The argument you hear over and over again is that indexing means all companies will move in price together. Good companies won’t be rewarded with higher prices, and bad companies won’t be punished.

There’s an absurdist logic here—that truly every dollar were invested in the same index. But each of us is out there acting in our own self-interest, constantly deciding how much small-cap we want, or which momentum strategy we like—even if we don’t explicitly state that as our goal.

Invisible Hand

Almost every investment choice we make is in fact a choice not to invest in something else, thus affecting relative prices, and factor ETFs focus the impact, thus increasing the effect. Each of us is our own tiny invisible hand, forming an invisible octopus pulling on the levers of the market.

We may not be able to articulate that that’s what we’re doing, but it doesn’t matter—our actions speak for us, as those broad decisions translate down into individual buys and sells in the underlying stocks.

So the next time you make that factor ETF trade, take comfort in the fact that you’re doing your part to keep the market healthy—no matter what the haters say.