First of all, I’m a big fan of ETFs, and a large part of my portfolio is invested in them…
These days, a huge share of the money flowing into equities goes through ETFs and other passive investment vehicles. These funds generally don’t pick stocks based on their valuation or fundamentals. They simply buy stocks according to their weight in the index.
If an increasingly large share of market demand is therefore insensitive to valuation, could this be weakening the role of price? Stocks can rise simply because of persistent passive inflows, rather than because investors have reassessed their fundamentals.
And there’s potentially a loop here: the more a stock or sector rises, the larger its weight becomes in a market-cap-weighted index, which means passive funds automatically allocate more capital to it. More inflows push prices higher, increasing its index weight even further, and so on.
The CAPE ratio shows the S&P 500’s price divided by the average inflation-adjusted earnings of the previous 10 years ([https://www.multpl.com/shiller-pe](https://www.multpl.com/shiller-pe)). We’re currently at levels that have only been seen a handful of times in history, which brings me to the real question: **could the continued growth of passive investing actually be contributing to market valuations becoming detached from fundamentals?** Are we gradually moving toward a market where prices are increasingly driven by capital flows and index mechanics, rather than by fundamental analysis and investors’ assessment of intrinsic value?
What do you think?