Motley Fool Hidden Gems Investing - Are Index Funds Making the Market “Irrational”?

Starting point is 00:00:00 Are index funds making the market irrational? You're listening to Motley Fool Hidden Gems Investing. Welcome to Motley Fool Hidden Gems Investing. I'm Jon Quast, and I'm joined today by Foolish contributors Matt Frankel and Rachel Warren. Before you dive into today's episode, do yourself a favor. Head over to news.fool.com and sign up for Breakfast News. It's a free daily email from The Motley Fool, landing in your inbox by 7.30 a.m. every morning, packed with the stories long-term investors actually want to know about. So we're going to tackle some topics today on today's show. We have actually two topics about ETFs from our mailbag, something like that you wouldn't necessarily find in Breakfast News,

Starting point is 00:00:46 but you might find something in Breakfast News similar to the story we're leading with here, And that is the topic that we have regarding SK Hynix. Now, SK Hynix is a computer memory company based in South Korea, and it's already publicly traded there in South Korea. But as early as this week, it does plan to list some American depository shares here in the U.S. or ADR. It's going to trade under the ticker symbol SKHY, and it's targeting to sell nearly 178 million ADR shares.

Starting point is 00:01:20 That will hopefully raise roughly $28 billion. It needs some money to build new factories and furnish them with chip making equipment. Now, one could say with AI, GPUs aren't holding anything back. It's the computer memory finding that specifically that high bandwidth memory. That is what these companies need right now. That is what we are not making enough of. And my first question here to you, Rachel, is what exactly is high bandwidth memory and who makes it? So high bandwidth memory or HBM, as it's commonly known for short, that's basically

Starting point is 00:01:57 the ultimate data superhighway for artificial intelligence. So traditional memory chips sit far away from the computer processor that is creating major data traffic jams, particularly in the age of intensive AI applications. So high bandwidth memory aims to solve this by stacking memory chips vertically, like a skyscraper, if you will, and placing that entire stack right next to the main processor. So this lets massive amounts of data travel, in some cases up to 10 times or more faster while using way less power. And so in short, we're at a time where AI processors are constantly starved for data. High bandwidth memory is the only memory fast enough to keep them fed. Now, right now, making these chips, it's so complex. It's so expensive. There's only

Starting point is 00:02:42 three companies in the world that control this entire market. And SK Hynix is the undisputed king of the mountain of this space. They command over 50% of the market as the primary memory supplier for NVIDIA's AI chips. Now, the other two players are Samsung, a global memory giant also based in South Korea, and Micron, the only major player based in the US. So because building these high-tech factories requires billions and billions of dollars, SK Hynix is coming to Wall Street to secure the cash they need to stay ahead in this very, very intense race. I think that so many investors missed the whole memory trade because historically memory is such a commoditized market and there's so many fears related to historic patterns when it comes

Starting point is 00:03:26 to this commoditization. But right now it is enjoying these companies, specifically SK Hynex enjoying these incredible business economics, I would say it's very smart for it to capitalize on the trend right now, go public here in the U.S., raise that capital that it needs. So it's good IPO timing, no doubt. I am curious here about long-term shareholders. Do either of you think that SK Hynex is a good investment when it comes public? Or are you looking at that $28 billion that it's going to be raising and saying, maybe there's a secondary beneficiary here because that money is going to go somewhere. Yeah, I mean, there's no denying that SK Hynix, they're riding an incredible wave and timing this U.S. listing during what is essentially peak AI euphoria. I

Starting point is 00:04:14 think it's a brilliant move from a corporate perspective. Now, I am not planning to buy shares at any point in the near future. And my hesitation comes down to a few things. Obviously, there's capital intensity, but there's also kind of the long-term cyclical risk. Building and equipping these facilities requires an astronomical amount of cash, as I was discussing. As a shareholder, my concern is that buying in today means you're betting that AI demand will remain hot enough or long enough to absorb all this new capacity. Even if it does, there is a lot of excitement that's baked into the stock right now. I prefer not to buy newly listed stocks straight of the gate, I understand SK Hynix is listed internationally. Now, if SK Hynix is deploying

Starting point is 00:04:54 billions into infrastructure, a massive portion of that capital flows directly into the order books of a lot of companies, including the semiconductor equipment giants like ASML, Applied Materials, Lam Research. Those are companies, those are equipment suppliers that essentially get paid to furnish and tool these factories up front. That's actually much more where my interest personally lies. There's significant revenue backlogs that are really locked in regardless of whether the memory market faces some kind of a supply gut glut a few years down the road. So for me, I'm more interested in capitalizing on that kind of guaranteed CapEx. But I certainly see that there will be many investors that are primed to buy shares of SK Hynix.

Starting point is 00:05:35 Yeah, so I'd add a few things here. So first, I'm not surprised at all to see this listing. In fact, I'd argue that it would be irresponsible not to raise capital through equity sales at these levels. You know, Micron's valued at over a trillion dollars. I think they should raise more capital if they need it. Having said that, you won't see me buying SK Hynix or Micron at these levels anytime soon. Rachel's right that the equipment suppliers are really the play to watch here, but I really don't put all three of them in the same basket. So specifically, ASML is the only company that makes those EUV lithography machines, and their order book is already stretched out for years. It's not just a memory-specific play. So whatever the industry is doing in a few years,

Starting point is 00:06:15 it's going to be fine. On the other hand, like LAM Research is much more of a memory play. That makes up more than half of its revenue. So I'm a little bit more concerned about that long-term, especially if this remains a commoditized business. Applied materials, I'd kind of put in the middle ground. It's got a very diverse revenue stream, great demand, not terribly levered to the memory business, but it's not exactly a monopoly like ASML has. So the equipment names aren't exactly immune to cyclicality. I mean, look at 2023 when all of the memory companies

Starting point is 00:06:49 that we mentioned cut their CapEx around the same time in response to slowing demand, all the equipment makers took a big hit. So if AI is truly a structural change for the memory industry and reduces the cyclical nature of it, all three of them could be big winners but that's still a very big F at this point. Well, based on my portfolio, I think I'm taking

Starting point is 00:07:11 the bet that it's an F and hoping that this continues to be a structural change in the market. Well, after the break, we're going to dive into the mailbag, looking at some interesting ETFs that have to do with private companies. You're listening to Motley Fool Hidden Gems Investing. Welcome back to Motley Fool Hidden Gems Investing. I'm going to be honest, The news over the weekend was pretty thin, but I'm actually pretty thankful for that because it does allow us to double dip into the mailbag today. And first up here, we do have a question about some ETFs, and I'll just read it as it is. Now that SpaceX has debuted and other AI companies are close to IPOing as well, what happens

Starting point is 00:07:52 to ETFs that hold shares of these companies after they go public? I know that XOVR and VCX and other ETFs hold pre-IPO shares of one or more of them, but have they stated whether they will hold them for the long-term or flip them when possible? Since SpaceX had a nice pop but is now settling down, is one just better off avoiding the ETFs and trying to buy the shares directly

Starting point is 00:08:17 if one believes the narratives? So to me, the listener is basically asking about ETFs in general, but also mentions two ETFs specifically. The ones that he mentioned specifically are ER Shares Private Public Crossover ETF and the Fundrise Innovation Fund. But I think we should mention before we go any further that those two ETFs, they're actually not quite the same thing. There are some differences that are important to point out. Yeah. So the biggest difference is one just between these in general and standard ETFs is that they invest in private companies alongside some public ones.

Starting point is 00:08:51 the XOVR, which is the ER shares private public crossover ETF, kind of a tongue twister. It's a traditional ETF. It happens to own private assets alongside a portfolio of mostly publicly traded stocks. I think a 15% cap is what they set there. I think companies like NVIDIA, Palantir, et cetera, those make up the bulk of the fund. On the other hand, VCX, the Fundrise Innovation Fund, that's actually a closed-end fund that is much more weighted toward private companies. it's also not a liquid ETF meaning that it has quarterly redemption windows when you can sell shares if you want to and even those are limited there's no real secondary market for the shares it's really tough to cash out whenever you want to so the bottom line is that the ER shares

Starting point is 00:09:35 private public crossover is the better option if you want to be able to readily cash out of your investment when you want to but if you really want more of a concentrated play on private companies, that Fundrise Innovation Fund is the way to go. So, you know, it's important to note that they're not really interchangeable products. And like any ETF, you should read the prospectus. But in this case, it's really important to know the differences, know what each one holds and know the fee structure of each one, because they're somewhat different and somewhat complicated in the Fundrise Innovation Fund before you decide to invest in either. Yeah, I mean, imagine buying into one of these things and not knowing that you can't sell when you want to. That would be a

Starting point is 00:10:17 really important thing to know. But now we move on basically two questions here from the from the listener. The first is, will these ETFs keep holding SpaceX long term, the ones that invested before the IPO? Rachel? Yeah, to address that question, the answer is generally yes. I mean, Matt did a good job of explaining how these funds are going to handle things a bit differently with when it comes to SpaceX. Now, ER Shares has stated that they view SpaceX as a long-term conviction holding. And they did the exact same thing, essentially, with a company like Klarna. You know, they held shares through its public listing. Now, similarly, the Fundrise Innovation Fund operates similar to a public venture capital fund, and their goal is to back these structural

Starting point is 00:11:00 tech giants for the long haul. So they will essentially continue managing SpaceX as a core holding within their broader portfolio. Yeah. I mean, it's also worth noting that there are post IPO lockups that restrict insiders, pre IPO investors from selling for a specific time period. With SpaceX, it's like seven different tranches that the lockups expire. It's really non-standard and it's really not that long of a podcast to go through all seven tranches and when they kick in. But the thing to note here is that lockup periods can apply to ETFs that hold these shares as well. If they hold them before they were public companies, then they become public. And that's to prevent if an ETF owns, say, 2% of a private company, that they immediately

Starting point is 00:11:40 dump that when it becomes public and collect the windfall. So keep that in mind as well when you think about whether or not and when these companies can sell. And if you're wondering why it matters whether or not an ETF holds shares of a company or not, we're going to tackle that more in our next segment. But before we move on, I do want to hit the second part of the question here from the listener, and that is, should one invest in these ETFs or just buy shares directly once they go public? And I will say, specifically with the XOVR ETF, that helps investors buy shares of companies before they go public. And so the underlying premise of the fund, once a company goes public, it seems like you don't need that anymore because it is available publicly. But

Starting point is 00:12:24 I don't know, Matt, any comments to add? John, the short answer is I wouldn't buy either of specifically for SpaceX exposure. So even if you don't want to own the stock or even if you don't want to own the stock directly, but want to own it, there are easier ways to go, especially now that SpaceX is officially part of the NASDAQ 100 and therefore will be added to much lower cost ETFs that will track it and will be pretty concentrated in it. But these could be a good way to go if you want SpaceX exposure and that private company investing all in one place. The two funds are, there's something an individual investor would really have a tough time were an impossible time replicating on their own.

Starting point is 00:13:01 So my general thought is that you have a very, if you have a very strong conviction in SpaceX, just buy the stock directly, save yourself the fees. If you want exposure to SpaceX and other big tech companies without owning them directly, I use this to get exposure to Nvidia, for example, use a NASDAQ 100 fund or something similar. If you want the public and private company exposure

Starting point is 00:13:23 all in one, decide which of those two ETFs best meet your needs and go from there. So you really have to decide which of those categories you fall into. Yeah, I think that's right. You know, personally, SpaceX is not a stock I'm interested in investing in, at least not at this point in time. I mean, I won't deny that the company's achievements are historic. The CapEx required to move forward on a lot of Musk's goals remain astronomically high. I think the regulatory hurdles are constant.

Starting point is 00:13:48 And also the path to consistent profitability is another element that worries me. I will say, you know, funds like XOVR and VCX, those are really diversified portfolios. So if you are an investor that tends to put cash, you know, in the public markets, but you also want that exposure to those very, you know, highly anticipated names that could be going public in the next year or two, like OpenAI, like Anthropic, that can certainly be a good way to go to have some exposure in your portfolio there. Now, for SpaceX, if you believe the story behind the business, if you want exposure to the stock, that diversified approach could also work. Now, for me, the high execution risks mean I'm staying on the sidelines for this one, but watching with a lot of interest to see how the stock performs in the next year or two. Well, if you're still wondering about ETFs after the break, we're going back into the mailbag to talk about potentially how they might move markets in irrational ways. You're listening to Motley Fool Hidden Gems Investing. Welcome back to Motley Fool Hidden Gems Investing. On a quick note, you can send us

Starting point is 00:14:54 questions like this to podcastsatfool.com. We love to take your questions when they're foolish, when they are short enough to read on air. Just send them in. If you have a question for Rachel, Matt, or myself, anyone on the show, just keep them foolish. Podcastsatfool.com, podcastsatfool.com. Okay, so our second question from the mailbag today goes like this. I'm a data analytics professional working in the co-op energy field. I enjoy trying to apply analytical thinking to the market, but it's not my expertise. I listen to the full podcast daily as I commute in my EV. There is persistent talk US equities, specifically S&P 500 being overvalued. I would really like to hear experts talk about expected retirement liquidations versus actual retirement liquidations by generation. my hypothesis, if there are more net holders of equity and a growing passive investment into the same equities, thanks to ETFs, 401ks, et cetera, would we not expect behavior that is irrational because of structural shifts, not actual human choice? Thanks. Here's what I like about this

Starting point is 00:15:57 question, guys. This person is admitting that they are not an expert, but that is okay. You do not have to be an expert to be an investor. And really, he's dialing into this analytical instinct here that he has as an individual investor. And he's saying, look, I feel like maybe there's a structural shift happening in the market, but some people are talking about it like it's an emotional shift. So trying to understand the difference between structure and emotion, I really like the instincts here. Rachel, what do you think? Yeah, I think the listeners instincts are spot on. And it also of shines a light on a reality that I think a lot of traditional models ignore. So we'll see, for example, overvaluation in the S&P 500, but that isn't really retail FOMO or investor greed.

Starting point is 00:16:44 A lot of it goes back to a very mechanical reality of a fundamental change in how the stock market works. So every two weeks or so, millions of paychecks are automatically swept into 401ks and passive ETFs. And the computers running these funds, they don't care if a stock is cheap or or ridiculously expensive. They are programmed to essentially blindly buy the index. Now, because the biggest tech giants are the most heavily weighted, the lion's share of every automatic dollar tends to get funded right back into those exact same companies. That can also naturally inflate their valuations regardless of human choice or individual investor appetite. What's interesting is that a lot of the old economic models assumed that when baby boomers

Starting point is 00:17:24 retired, that they would immediately dump their stocks to buy bonds and cash, which would naturally deflate the market. That has not borne out. In fact, modern retirement structures have turned them into what we would call permanent net holders. About the top 10% of those in the baby boomer generation hold over 70% of that generation's wealth. And so these wealthy retirees, they don't need to liquidate their stocks. They are just letting them ride, passing them down to their kids, their grandkids. So when you combine that wall of automated passive inflows with a generation of retirees with significant disposable income who are not selling their stocks generally, you do get a market that behaves in ways that might look

Starting point is 00:18:04 irrational to traditional value investors. But there's a very good reason behind the movements that we're seeing. Yeah. So let's add some numbers behind what Rachel just shared. So passive index funds made up less than 10 percent of all U.S. equity funds back in the 90s versus is about 50% today. Because of this, it's now estimated, and things like algorithmic trading and programmatic things that they do on Wall Street, it's estimated that about 60% of all trading volume is now systematic and not discretionary. So the listener's absolutely right. The old 4% rule, it made certain assumptions that retirees would sell their equities, cash out, go to bonds. And a lot has changed since then, as Rachel referred to as

Starting point is 00:18:48 modern retirement structures. RMDs, for example, now start at 73. That's significantly later than they used to start, where you have to start taking money out of your retirement account. Wealthy retirees, they often withdraw only what they have to. And more estates are now being passed to heirs with stocks that are getting stepped up basis and are never withdrawn or sold at all. So passive investing has created this kind of self-reinforcing loop where passive money flows into the market, but not really out as much, the biggest stocks go up, they become an even bigger share of the index funds, and the next pass of money in creates even more concentration and this cycle repeats and repeats and repeats. So I'd push back that the market isn't behaving

Starting point is 00:19:30 irrational here, but the behavior, it's a rational response to that new reality that we're talking about. So one thing I'd watch out for is if the passive flows ever went net negative, which could certainly happen and has happened in things like deep recessions. The same passive mechanics that caused inflated prices in the first place could deflate them using the same exact mechanism. We saw this during the initial COVID crash. A lot of that was attributed to algorithmic trading. So it's not the discretionary traders that are driving prices up, but that could also drive prices down. So what I hear you saying here is that, yes, maybe perhaps ETFs and index funds have changed some structural market behavior compared to 30 years ago or 50 years ago.

Starting point is 00:20:18 Things are quantifiably different now. My big question here is, if that's true, what do I have to do as a DIY investor? Do I need to change things? Do I need to be a rational investor, as opposed to what I'm seeing is irrationality, or maybe we even need to define what does irrational even mean? Rachel, I'm going to let you go first here with this big question. What do I need to do? So in traditional finance, a rational, quote unquote, stock price would reflect a company's actual business fundamentals, like revenue and earnings. Now, passive investing kind of flips that on its head because it's very predictable. You've got the computers, Obviously, the algorithms that are managing these flows are not analyzing balance sheets.

Starting point is 00:21:04 They're matching market weights. And that can and does create a distortion where, you know, the biggest companies at the market get the most money simply because they're already big. You know, that can really untether stock prices from actual corporate performance. So I do want to underscore that. Now, does this mean you need to change how you invest? You know, obviously, we can't give personal investing advice. But for most of us, and those of us certainly here with The Motley Fool, it really means

Starting point is 00:21:27 doubling down on that philosophy of long-term diversification. So instead of letting passive flows, you know, trap us entirely in a few top-heavy mega caps, it's really important to build a robust portfolio, you know, 50 or more high-quality individual stocks across different industries. And buying individual companies, it allows us as investors to really look at the underlying core business fundamentals that those algorithms ignore. Now, that said, not everyone has the time or the interest to manage all those individual stocks. That's completely understandable. but this is something that can be adapted to individual investors, whether you're using equal weighted index funds or actively managed funds as your core foundation. But I think the

Starting point is 00:22:05 key takeaway is ensuring that our portfolios are truly diversified so that we're not entirely exposed to the whims of a few of the biggest companies in the world. So, John, you had mentioned that we might want to define irrational here. So let's do that. Let's take a step back and define what that means. So it means that in investing, irrational means that a stock, is its price is disconnected from its underlying business fundamentals. It doesn't mean that it's expensive. It doesn't mean that it's cheap. It just means that the price doesn't go with its underlying business. A stock that's trading for 100 times earnings or 40 times sales could be completely rationally priced if the growth justifies it. So I'd argue that passive

Starting point is 00:22:45 flows aren't really irrational or rational. Rather, they're indifferent to price, which is arguably more dangerous, but it's self-sustaining loop of, you know, passive money flowing in and driving the higher, the biggest stocks up, you know, that can really kind of have an interesting dynamic. So I'd also say the passive flows that we're talking about don't really move the market much on a day-to-day basis. The volume's rather smooth and continuous. It's not like, you know, the Vanguard S&P 500 index fund is putting a trillion dollars to work like today. It's a very continuous motion, but over time, they certainly can make a difference.

Starting point is 00:23:20 I mean, there have been studies done, mega cap performance in the passive era, which is what we're in now, is more dramatic than it was a decade ago, even when you consider the changing fundamentals. I mean, obviously, NVIDIA is stronger today than it was five years ago. You can certainly tweak your investment strategy

Starting point is 00:23:37 because of this. That doesn't mean trying to time the market because of what passive indexing is doing. I mean number one be aware of the concentration risk in your passive index funds that's a big tweak that I've made an S&P 500 index fund isn't the diverse investment it was you know 10 years ago I expect a longer payoff period when you invest in deep value stocks which is a big focus of mine passive flows they affect the large caps most I can create opportunities for long-term patient investors in things like small caps and international stocks. And periodic rebalancing

Starting point is 00:24:13 is more important than ever when passive investing can push certain stocks higher regardless of their current valuation. So those are just some of the tweaks that I've made to my own investment strategy over the past, say, 10 years or so. So yeah, take those for what they're worth. Well, I think it's important for all of us foolish investors to never push away from growing as an investor because there's always something that we can learn to improve for the future long-term health of our portfolio. So that's what I'll be doing. That's all the time we have for today's show. Thank you so much for listening. As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations

Starting point is 00:24:51 for or against, so don't buy or sell stocks based solely on what you hear. All personal finance content follows Motley Fool editorial standards and is not approved by advertisers. Advertisements are sponsored content and provided for informational purposes only. To see our full advertising disclosure, please check out our show notes. Thanks to our producer, Dan Boyd, and the rest of the Motley Fool team, for Matt, Rachel, and myself. Thank you so much for listening to our show today, and we will see you again soon.

Motley Fool Hidden Gems Investing - Are Index Funds Making the Market “Irrational”?

There aren't comments yet for this episode. Click on any sentence in the transcript to leave a comment.