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Since public interest in ETF is growing rapidly, and any novice investor looking where to put their money would probably see recommendations to invest in ETF literally within the first page of the most naïve google search on the topic, I've been thinking under what circumstances that might become a bubble and what this bubble might look like.

One scenario came up in my mind, and while being unlikely, it's theoretical possibility is still bothering me somewhat. It looks like the biggest risk in ETF is that it might blindly inflate stocks that happened to be part of the index, but belong to the companies that are not doing so well. If there are many companies like that, and their inflation is significant, the bubble might burst when conventional invertors notice these overpriced assets and dump them.

The paradox of the index, say S&P500 is that it's abstract and wouldn't tank too much on its own, because 50 stale companies will be replaced by companies that were in positions 500-550 before. Like, after all, there always will be top 500 companies in the US. Even if they collapse overnight, the next day their position will be taken by another 500 companies.

But what would happen to VOO over this night? Vanguard needs to sell those stock real fast and repurchase new stocks to reflect changes in index? Is it possible that gap between VOO and the S&P500 itself becomes very significant and unfixable? Can this theoretically happen?

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    According to the answer there, there were as high as 60 companies swapped in a particular year. One important thing about market capitalisation weighted index is that the companies being swapped are usually the smallest in the population. The smallest 50 companies in S&P 500 only make up 0.8% of total weight. Whereas the top 6 (AAPL, MSFT, AMZN, FB, GOOGL, GOOG) make up 22.5% of total weight.
    – base64
    Oct 7, 2020 at 4:42

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The paradox of the index, say S&P500 is that it's abstract and wouldn't tank too much on its own, because 50 stale companies will be replaced by companies that were in positions 500-550 before. Like, after all, there always will be top 500 companies in the US. Even if they collapse overnight, the next day their position will be taken by another 500 companies.

You may be misunderstanding how stock indexes work, as if the S&P were allowed to "cheat" by being computed from the instantaneous top 500 stocks. They play fairer than that. Changes in the composition of an index are announced in advance. When they take effect, the index is defined to remain unchanged at the instant when an old stock is replaced by a new one. This corresponds closely to the value of an actual portfolio that sells the one and buys the other.

When a stock in an index plummets and is subsequently dropped, that loss leaves a lasting dent in the index level. To bring in the new stock and rebalance, the index has to take away from its weighting in all the other stocks. In the remote event that all stocks in the index suddenly go to zero, the index goes to zero and is kaput forever. Even if the index tried to switch to other stocks, it has no "capital" with which to do so, and the math would leave it at zero.

Thus, indexes are calculated in a way that makes it possible to replicate them with actual portfolios such as ETFs. This makes sense, since one point of indexes is to define a fair "benchmark" with which to compare the performance of any given portfolio.

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    Won't these announcements of composition changes allow traders to front-run ETFs?
    – Flux
    Oct 7, 2020 at 10:04
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    @Flux Yes, but the ETFs themselves try to front-run too.
    – nanoman
    Oct 7, 2020 at 11:08
  • But this does effectively mean, that if a critical mass of companies gets removed from the index, no matter how much of a notice there is, the gap between ETF and the index will get very significant?
    – Alex
    Oct 8, 2020 at 3:36
  • @Alex No, if the ETF buys and sells stocks at the same price at which the index adds and removes them, they will track each other no matter how many stocks turn over. Think of the index definition as a "paper trading" calculation of a defined hypothetical portfolio's return. If the index removes a bunch of stocks and doesn't replace them, it now has a higher weight on each of the remaining stocks, like a portfolio that rebalances and becomes more concentrated.
    – nanoman
    Oct 8, 2020 at 3:50
  • @nanoman: What would happen if e.g. index funds own 1,000,000 shares of some stock which gets removed from the index, but at the time of removal there are $500,000 worth of bids pending for $10, but the total value of all other bids is only $500,000? Would some index fund holders get $10/share and others $0.50, or would all get $1/share, or how would that work out?
    – supercat
    May 7, 2022 at 18:58

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