Everything You've Been Told About Index Funds Is No Longer True: Phil Bak

It's "madness"...

Today I’m happy to offer my readers the latest from my friend Phil Bak. Phil has appeared on my podcast and runs his own Substack called BakStak.

He specializes in ETFs but I also love his perspective on all things macro, markets — and more importantly, exactly how absolutely ass-backwards our entire financial world is. You can follow him on X here.

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The Rikishi Moment

Let’s talk about what is happening in our capital markets, and specifically in our index funds, but before we do we need to understand what a fall from grace looks like. And to do that we need to talk about Pete Rose.

Pete Rose wasn’t just a baseball star, he was every baseball fan’s idea of a baseball star. He was all elbows and dirt and hustle and toughness. And then he was a player-manager. The face of a franchise. The face of a sport.

And along the way he made some mistakes. As it turned out he made the worst kind of mistakes for his time, which was to gamble on the sport. It’s funny to think about it now, with sports gambling available on every phone and advertised non-stop at every sporting event. But back then the world was more concerned with old fashioned concepts like integrity, and the league decided to make an example out of Pete Rose.

15 years later, a broken Pete Rose was trying to pay the bills by lending what was left of his celebrity to WrestleMania. And he soon found himself in the ring with a 400-pound Samoan wrestler named Rikishi.

Now here is where I have to drop a ‘viewer discretion advised’. Because Rikishi had a signature move he called stinkface. Stinkface is as classy as it sounds: Rikishi would trap an opponent sitting in the corner of the wrestling ring, turn around, back up, and shove his giant rear end into the opponent’s face while the crowd went insane.

You can see for yourself, if you want. It is as bad as it sounds.

the moment before

As Rikishi was rubbing his gigantic ass on Pete Rose’s face, if you look closely you can see something you won’t often see. Something in Pete’s eyes. A mixture of sadness and acceptance. A realization of how far he has fallen. Eyes that are no longer raging against where he is in life, but instead eyes that look dazed and tired and accepting of this new sad reality.

John Bogle is no longer with us, and I can only imagine how he would look upon what is happening to index funds now. I can only imagine the same sad eyes. I can only imagine the same dazed and tired acceptance, as his great invention coming from such great heights collapses into the sewers of fraud.

If you’ve been reading my stuff for a long time, and particularly back when I used to write more about stocks and ETFs, then you can probably guess where I am going. But for those of you who are new here, I’ll catch you up. This is what actually happened:

• Low cost investing was a powerful narrative that put the little guy against Big Greedy Wall Street

• That narrative drove flows into passive index funds

• The flows drove performance, causing the market cap weight (reverse-size & momentum) factor to outperform all others

• Outperformance led to yet more flows, and the circular loop was complete

• Options volume flipped equity volume, as derivatives tied to the largest indexes are driving prices even more so than index funds

• And just like that, valuations no longer matter to markets

All of this brings us up to date, and to the Rikishi moment we are now facing. That moment is the SpaceX IPO.

First, NASDAQ changed its Nasdaq-100 index rules to make it easier and faster for newly public mega-cap companies like SpaceX to enter the index. The rule changes appear to weaken traditional index standards around free float, liquidity, investability, and replicability. Time will tell if this is good or bad for investors, but what we do know for certain is that it was very good for NASDAQ’s efforts to market their exchange as a primary listing venue to SpaceX.

Now you can say that it is insane to allocate stocks by primary listing exchange, and of course you’d be right to say so. I’ve been in those pitch meetings, and the reasons why one company might list on NYSE versus NASDAQ have absolutely nothing to do with what is good for the relative investment merits of the S&P or QQQ. I mean, we are talking about totally disconnected worlds.

For example, people think they are buying tech when they buy the NASDAQ 100, and they end up with Costco and Wal-Mart and a bunch of other stuff. And they probably just assume that they are getting some Oracle or Uber, but no, those companies chose to list on NYSE for reasons that have nothing to do with your portfolio, so you miss those.

It’s madness.

But it’s always been that way. And this is even worse. Because this isn’t only about listing venue. All of the index companies made changes to their index methodologies just to shoe-horn SpaceX and Anthropic and OpenAI into their indexes. And if valuation still mattered, the valuations at which index fund investors will be buying into these companies will make you want to vomit.

Here is the damage, per Hedgeye:

Rule changes for the SpaceX $SPCX IPO:

Index providers waived the profitability requirement and cut the seasoning window from 90 days to 5.

This forces over $30 trillion in passive 401k and retirement money to buy SpaceX at IPO valuations.

Bloomberg Intelligence estimates S&P 500 funds must absorb 19% of SpaceX’s float within 6 months.

Russell 1000 and Nasdaq 100 funds will absorb 24%.

The rules built to protect passive investors:

1. S&P 500 has required 12 months of trading and 4 quarters of GAAP profitability since 2002. Both waived.

2. Nasdaq cut its inclusion window from 90 trading days to 15.

3. FTSE Russell cut its to 5.

All three benchmarks are now structured to buy SpaceX at IPO pricing.

This is the moment. The shark-jumping of index funds. The moment that the Great Pete Rose stared into Rikishi’s huge ass with that look of despair.

Investors are no longer just outsourcing security selection. They are outsourcing asset allocation, IPO discipline, liquidity judgment, valuation discipline, venue selection and prudence. They have given away all agency over their trades to index committees that will blow around wherever the wind takes them.

The indexes are no longer neutral. They are making active bets, and they are making those bets on the frothiest of companies, and at peak valuations.

Active management has never had a better opening. Direct indexing has never been more relevant. A great transition is finally close.

Everything you’ve been told about smart-but-boring index funds is no longer true.

Get out while you can. Pick your own methodology. Pick your own factors. Choose your own stocks. And reclaim your own agency over your portfolio.

QTR’s Disclaimer: Please read my full legal disclaimer on my About page here. This post represents my opinions only. In addition, please understand I am an idiot and often get things wrong and lose money. I may own or transact in any names mentioned in this piece at any time without warning. Contributor posts and aggregated posts have been hand selected by me, have not been fact checked and are the opinions of their authors. They are either submitted to QTR by their author, reprinted under a Creative Commons license with my best effort to uphold what the license asks, or with the permission of the author.

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