Are Index Funds Making the Market “Irrational”?

0:01Matt Frankel: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, 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.

0:54Matt Frankel: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. 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.

1:38Matt Frankel: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 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.

2:22So 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, you know, 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 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, global memory giant, also based in South Korea, and Micron, the only major player based in the U.S.

3:02So 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.

3:12Matt Frankel: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 to this commoditization. But right now it is enjoying these companies, specifically SK Hynix, 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 Hynix is a good investment when it comes public?

3:55Matt Frankel: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 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. I mean, building and equipping these facilities requires an astronomical amount of cash, as I was discussing.

4:33You know, 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 out of the gate. I understand SK Hynix is listed internationally. Now, if SK Hynix is deploying 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, Land Research.

5:05Those are companies, those are equipment suppliers that essentially, you know, 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 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.

5:35Jon Quast: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.

6:10Jon Quast:It's not just a memory-specific play. So whatever the industry is doing in a few years, it's going to be fine. On the other hand, like, Lamb 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 that we mentioned cut their CapEx around the same time in response to slumming demand.

6:54Jon Quast: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 if at this point.

7:08Matt Frankel:Well, based on my portfolio, I think I'm taking the bet that it's an if 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.

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7:59Matt Frankel: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 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?

8:39Matt Frankel: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 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.

9:14Jon Quast: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. The XOVR, which is the ER shares private public crossover ETF, kind of a tongue twister. As 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.

9:49Jon Quast: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 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.

10:25Jon Quast:And like any ETF, you should read the perspectives. 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.

10:42Matt Frankel: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 really important thing to know. But now we move on. Basically, two questions here 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, ERShares has stated that they view SpaceX as a long-term conviction holding.

11:15And 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 tech giants for the long haul. So they will essentially continue managing SpaceX as a core holding within their broader portfolio. you.

11:38Jon Quast: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 nonstandard. 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 these 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, you know, and that's to prevent if an ETF owns, say, 2 % of a private company, that they immediately dump that when it becomes public and collect a windfall.

12:14Jon Quast:So keep that in mind as well when you think about whether or not and when these companies can sell.

12:20Matt Frankel: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, you know, specifically with the XOVR ETF, that helps investors buy shares of companies before they go public. And so the kind of the underlying premise of the fund, once a company goes public, it seems like that kind of you don't need that anymore because it is available publicly.

12:54Matt Frankel:But I don't know, Matt, any comments to add?

12:56Jon Quast:John, the short answer is I wouldn't buy either of these 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 or an impossible time replicating on their own.

13:31Jon Quast: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 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.

14:08I 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. 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.

14:47Now, 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.

15:05Matt Frankel: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 Investor.

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16:44Matt Frankel:Exclusions apply. See homekeeper.com slash price match for details. Welcome back to Motley Fool Hidden Gems Investing. On a quick note, you can send us questions like this to podcast at fool.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. podcast at fool.com, podcast at fool.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.

17:21Matt Frankel:I listen to the Fool 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 question, guys. This person is admitting that they are not an expert, but that is okay.

18:00Matt Frankel: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 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.

18:38But that isn't really retail FOMO or investor greed. 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 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.

19:17What's interesting is that a lot of the old economic models assumed that when baby boomers 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, you know, retirees with significant disposable income who are not selling their stocks generally, you do get a market that behaves in ways that might look irrational to traditional value investors.

20:04But there's a very good reason behind the movements that we're seeing.

20:08Jon Quast:Yeah, so let's add some numbers behind what Rachel just shared. So passive index funds made up less than 10 % of all U.S. equity funds back in the 90s versus 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 is absolutely right. Like 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 modern retirement structures.