The Unintended Consequences of Mass Index ETF Adoption
A blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by experts – Burton Malkiel, A Random Walk Down Wall Street
Admittedly, A Random Walk Down Wall Street has always been one of our favorite books on finance. The problem is that it also represents an attack on active portfolio management. That in turn, affects price discovery, liquidity and volatility.
In recent years, Equity Capital Markets have wavered. In this case, Equity Capital Markets means companies going public (“IPOs”) and raising secondary capital through follow-on offerings. The problem is that the stock market since COVID has done extraordinarily well. This begs the question, why are IPOs and follow-ons performing so poorly? What we will posit and then prove in this blog, is that outside of small pockets of time, the difficulty to IPO and price companies will only increase as time goes on and we have only ourselves to blame. In fact, this increasing difficulty is a feature, and not a bug, of modern capital markets.
In many ways, the idea of Permuto’s Dividend Certificates (DC) and Asset Certificates (AC) – Permuto’s AC/DC product – providing the ability to split a stock into its dividend and asset (everything except the dividends) components and publicly trade each under its own CUSIP on a national exchange and the Chia blockchain, was borne out of this attack on active investment strategies. As background, active managers are often compared to a specific benchmark (e.g., the S&P 500). In doing so, the active manager has to hold the same percentage of exposure to each sector within their portfolio as the underlying benchmark. In order to gain exposure to these sectors, managers are only allowed access to the same set of stocks utilized by the underlying benchmark.
The problem is that fund flows into passive vehicles place money indiscriminately across an index rather than allocate funds in a way that is consistent with fundamental principles. This makes it difficult for active managers to keep up with the returns of the broader index by investing into smaller allocations within the index. Many active managers currently hold outsized percentages of the “Magnificent 7” because these have the heaviest index allocations.
Before Permuto’s AC/DC product, investors have only had two decisions for a specific investment to control returns within a specific portfolio: 1) whether or not they like the stock in question, and 2) if they do, how large of a position to buy.
The Permuto AC/DC product adds a third paradigm which asks, in what exposure level? For instance, if one looks at the price of Microsoft (MSFT) in the market and asks what their implied exposure to ACs and DCs is on a natural basis, the answer may be ~84% AC and ~16% DC (depending on valuation methodologies and assumptions). But consider a scenario where a manager believes that the stock is overpriced and will receive a re-rating of its valuation multiple while the company is expected to grow at ~10% per year. Instead of being forced to purchase a stock they believe may be overvalued, they are now able to utilize 100% of their capital to purchase DCs instead. This centers the investment around the operations of the business, and more specifically, whether or not their dividend will be paid and potentially increase. Previously, the ability to gain exposure to individual pieces of the return profile of a company was limited to very large investors executing bespoke transactions utilizing derivatives or swaps with elevated fees, and the vehicle was not perpetual.
So, how did we get here and why now for Permuto? We got here due to a little bit of human nature and a lot of technology. We will start with human nature, move into technology, and end with the undeniable proof that we had to start Permuto as soon as possible before the retreat from active management reached a point of no return.
Human Nature
“A Random Walk Down Wall Street” was published in 1973 so it is fairly easy to state that, for at least the last 52 years, people have been told that even the experts cannot beat “the market.” It is only human nature to logically question, if experts cannot outperform, then what chance is there for me?
The answer provided by pundits and “experts” since then? Purchase ETFs or colloquially, buy the market. Don’t even try to pick “winners” as it’s time-consuming and an effort in futility. We will get to the problem with this shortly.
Technology
In AI, Machine Learning, advanced algorithmic trading, etc., innovation abound. Many quant funds do not trade based on the underlying fundamentals of a company. They trade based on subtle patterns, momentum, mean reversion, volatility mismatch, or any number of strategies that have been studied and back tested ad-nauseum.
According to a federal reserve paper published in 2014, average hedge fund ownership of stocks on NYSE, AMEX, and NASDAQ in 2000 was 3% while in 2012 the average was 10% (with the 90th percentile holding 17% of the stock). The federal reserve painstakingly went through Form 13F filings, as well as the descriptions of the hedge funds, to discern true hedge funds from other institutional investors, mutual funds, and investment advisors. The trend is clear: hedge funds are becoming more and more dominant in the global investing sphere.
A better question may be to ask, what has happened between ETFs and Mutual Funds since 2012? The answer is more expected than remarkable. Per the federal reserve paper, from 2008-2012 mutual funds owned, on average, 34% of stocks. Today, according to ICI, active equity mutual funds as of April 2025 have $6.8tn in U.S. equities while passive index funds hold ~$11tn in U.S. equities. Given the current size of the U.S. equity market was sitting just over $52tn as of April 4th per Siblis Research index, ETFs make up 21.1% of U.S. equities and active mutual funds own ~13.2% of domestic equities and 18% of all equities. Given the ambiguity of whether the federal reserve included all equities in their analysis, mutual funds have lost between 16% and 20.8% of the market in the last 13 years.
In March and April of 2025, $57.3bn in value was removed from long-term mutual funds while $66.511bn in value was deposited into index ETFs.
Why Should Investors Care About This
Outflows are accelerating from actively managed equity mutual funds into passively managed equity ETFs.
Active investing serves as the glue of the market. When companies become overvalued by fundamentals-driven metrics, prices are corrected via shorting. When companies are undervalued, investors purchase based on these same fundamentals. Active investors serve as the rational market participants that allow for our markets to function efficiently.
This systematic undermining of the importance and effectiveness of fundamentals-driven investing will continue to undermine price discovery, exacerbate market volatility, and increase market correlation. We will dive deep into the first two as the last point is more of a hypothesis utilizing the first two items as inputs.
Price Discovery
Many people likely never think about the way stock prices are set, but in this case, it can be helpful to think in logical extremes. Let us assume that within the S&P 500, 90% of all outstanding stock is owned by ETFs of some sort.
ETFs are forced to purchase securities in specific ratios based upon the investment mandate laid out within their prospectus. For instance, S&P 500 ETFs purchase based upon a market cap weighting of the constituents of the index. Therefore, as inflows occur, the market cap ratios between S&P 500 constituents will remain the same, regardless of the actual performance of the companies in question.
If there are only ETFs placed in a position of buying, fundamentals no longer apply to what makes a valuable company versus a less valuable company. The only thing that matters is what the firm’s market cap was prior to the full removal of investors who cared about fundamentals from the market. Whether passive ETF holders know it or not, they are relying on fundamental investors to set rational, market clearing prices for index ETFs to properly function.
Volatility
This may sound like a tangential issue, but we are already beginning to feel its effects. On an inter-day basis, from 1990-2007, there were 59 instances of S&P 500 returns over |3%|. Of those, there were only 8 moves over |5%|. From 2008 to date, there were 141 over |3%| returns with over 35 resulting in over |5%|. Despite an average market cap over each period increasing by 178%, we are still seeing more frequent, larger swings in inter-day returns.
To prove that this is not simply a fluke exacerbated by a selection period, from 2020 to date, there have been 45 returns over |3%| of the S&P 500 in a single day, 13 of those were over |5%| moves. The average market cap of the S&P 500 from 2020 to date is also 387% larger than from 1990 – 2007. For a concept of scale, a 3% move in the S&P 500 from 1990 – 2007 was a $241.3bn while from 2020 to date the same move would constitute a 1.2tn move a gain which would have constituted 14.6% of the average value of the S&P 500 from 1990 – 2007.
Despite market caps, and the overall market becoming increasingly larger, |3%|+ percentage moves are occurring more frequently in the last 5.5 years than happened in the 17 years from 1990 through 2007.
So, why is this increased volatility occurring? We can break the financial world into a few large buckets. We have hedge funds (which tend to trade strategies rather than invest for the long-term), mutual funds (which invest for the long-term or invest a thesis), ETFs (that traditionally passively track an index), and Registered Investment Advisors (also known as RIAs, direct money into the other three buckets, but they are often also long-term allocators into single stocks). Most volume on a daily basis comes from fund flows into and out of ETFs and mutual funds and the reactions by hedge funds which in turn amplify the stock price moves. Fund flows can be estimated by hedge funds using various economic indicators and filings which they use to then trade their patterns. Specifically, a momentum fund can amplify changes caused by fund flows by investing after the ETFs allocate their new capital. After this occurs, RIAs and remaining mutual funds have to make a decision if they want to increase, maintain, or decrease their allocation. What started as a seemingly small $30bn inflow into ETFs (well within liquidity limits for market makers) can quickly get out of control as the hedge funds and long-term investors pile onto the same trades.
Market Correlation
In a lot of ways, we were very lucky the financial crash of 2007/2008 occurred when it did. Back then, market participants were mostly uncorrelated.
In financial circles, we are always looking for what the next catalyst is going to be for a large market crash or a recession. For a few years now, we have believed that AI and ETFs are that catalyst.
The AI macro trend will likely increase efficiency, which then increases productivity per employee which then flows down to increasing the cash flow of the firm. In almost all scenarios, it will also lead to job losses in the short term, just as every industrial revolution does in its early stages. This large scale, temporary, job loss will lead to mass reskilling of the population. Reskilling takes time and requires resources from individuals, both of which will likely cause individuals to remove capital from investment accounts to fund this change. That is where ETFs come in.
As we have shown in the sections above, the vast majority of cash inflows in recent years have been into ETF products. ETFs buy and sell securities indiscriminately, they do not care if a company is performing well or poorly. If large swaths of the population begin pulling out their ~$11tn of ETF investments to pay for living expenses and reskilling, the market reaction will be indiscriminate. When an individual sells their SPY or VOO, they are selling the dollar value of their ETF investment multiplied by the ETF weighting of every stock within the ETF.
So, why were we lucky in the financial crisis? From October 13, 2006 – February 20, 2009, MSFT, AAPL, and GOOGL returned (36.6%), 21.6%, and (18.9%) respectively. At the same time, Bank of America returned (93%) and most of the financial institutions were teetering on bankruptcy. This shows that active management still had some hold within the market. Tech companies were hurt less than financials but were still broadly hurt given the financial sector has an impact on all industries (lending, products, etc.,). Had ETFs been approximately the size of the market, in order for Bank of America to fall 93%, investors would have had to sell their ETFs to reduce exposure to the financial sector. If this occurred, all other stocks would have also been sold in order to accomplish getting out of owning the financial sector. In 2008, this would have likely also involved buying back sector ETFs that individuals would rather have exposure to, but that would only take place after a flash crash of the entire stock market.
Permuto Capital and How We Change It
For a long time, we have been unfair to fundamentals-driven investors. We have added products into the market that allow for other investors to invest across large swaths of equities at extremely low fee levels, added inverse and leveraged vehicles into single stocks or extremely customized buckets, and even added products enabling mass scale use of derivatives. In the same period of time, fundamentals-driven investors are supposed to invest in the traditional equity and beat the market without having gained any new tools.
At Permuto Capital, we are giving fundamentals-driven investors new tools that allow them to more closely match their portfolio construction to their investment thesis. Our Asset and Dividend Certificates enable investors to more specifically adjust their exposure to a company’s operations (via investing solely in their dividend) and the firm’s overall valuation (via investing in the Asset Certificate which is functionally the interaction between the firm’s valuation multiple multiplied by their operations less the value of the dividend stream). Fundamentals-driven investors can now be bullish on operational performance while being bearish on equity performance (long DC / short AC), bullish on equity growth but not believe in growth in dividend policy (long AC), or simply be a middle-aged investor that needs a specific amount of income from their portfolio but doesn’t want to sacrifice growth in the future for their retirement (perhaps 30% DC and 70% AC of growth stocks). In one particular example, a fundamentals-driven investor could have bought just a company’s DCs, and with a dividend reinvestment strategy, would have out performed the S&P 500 index on a stock that only traded up 21% over the same period.
Permuto is bringing optionality to fundamental investing. By forcing dividend cash flow streams to be valued separately from the equity of the firm, companies whose equity trades with a yield of 70bps will likely have DCs yielding north of 5%.
Broad-based ETFs are not inherently bad. For many, they are an efficient way to gain exposure to the stock market without needing to understand the nuances of investment strategy and portfolio construction. Unfortunately, at their current size, the act of investing without regard for fundamental valuation characteristics causes market inefficiencies. Between the periods of 1990-2007 and 2008 to date, the average daily S&P 500 return has increased 10.1% while the standard deviation in returns has risen 28.5%. We believe these are signs that these market inefficiencies are beginning to emerge.
It is our belief that the products of Permuto and the increasing levels of investment specificity that they offer will allow investors to more effectively correct these inefficiencies and in turn will help to enhance price discovery. We believe that enhancing price discovery will also enhance liquidity at levels that are supported by strong fundamentals, which should also reduce volatility in the long term.