The Gift of a Benevolent Providence

Suppose that I buy a popular exchange traded fund (ETF) tracking the S&P 500® today, leave it in my brokerage account for 20 years, and then sell it.  What return should I expect?  The answer, obviously, is that my return should reflect the movements in the S&P 500 (net of fees) over my 20-year holding period.  That this actually happens is a remarkable thing, and no less remarkable for being unappreciated.

The S&P 500, after all, is just a list of stocks, and its path depends upon the weighted average fluctuation in their prices.  The return of my ETF depends upon what someone is willing to pay me at whatever time I decide to sell.  That these two returns are the same is not the gift of a benevolent Providence.  It happens for two distinct reasons.

First, there is an active arbitrage community that continually monitors the relationship between the value of my ETF and the value of the underlying members of the S&P 500.  If the ETF is too cheap relative to the value of the index’s constituents, arbitrageurs will buy the ETF and short the constituents; if the ETF is too expensive, the arbitrage goes in the opposite direction.  In either case, arbitrage pushes the ETF toward its fair value.

Second, popular ETFs and indices are widely scrutinized by the investment and journalistic communities.  If something looks “off,” a news story or a cacophony of investor queries may follow.  This scrutiny helps to ensure that both index and ETF deliver on their objectives (in the S&P 500’s case, to reflect the most important companies in the U.S. stock market and, in the ETF’s case, to hold a portfolio tracking them).  Problems in a less-scrutinized product will be noticed less quickly, if at all.

Index funds are sometimes criticized for failing to promote market efficiency since, at the stock level, efficient pricing depends on the ability of fundamental analysts to assess firm values accurately, and index funds don’t do fundamental analysis.  For the market as a whole, however, trading in index-linked instruments is orders of magnitude greater than trading in individual stocksOne investors opinion of the proper value of the market as a whole is, a priori, no less valuable than another investors opinion of the proper value of Microsoft or Amazon.

 “Markets work best,” writes The Wall Street Journal’s Jason Zweig, “when they are both deep and wide, integrating sharp differences of opinion from many people into a single price at which investments can trade.”  Arbitrage and scrutiny forge a connection between prices at the macro and micro levels, improving the efficiency of the whole.

The posts on this blog are opinions, not advice. Please read our disclaimers.

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