Overview
Many ETF's are guilty of misleading the general investing public into thinking that the p/e ratio of an Index ETF is lower than it actually is.
Like accounting standards change, Index ETF marketers have changed how they calculate the p/e ratio of their various Index ETF funds are calculated.
SPY, a very familiar ETF to everybody familiar with ETF investing is only the tip of the iceberg of the problem.
If actual simple averages are used to calculate the p/e averages I suspect index returns would be much lower and p/e ratios much higher.
Imagine living in a world where facts aren't facts, numbers are not what they actually seem and the worst part of it all is the façade that is painted creates a sense of comfort in millions of people. I am not talking about politics, or philosophy, I am talking about index ETFs. The practice of utilizing harmonized p/e ratio averages with various index ETFs is widely accepted, hugely confusing and misleading to the general investing public. This issue, along with a few others I will mention in future articles are just a few of the main reasons I believe the currents state of the market is largely inflated. The purpose of this article is not to discuss the validity of p/e ratios in evaluating value or the ratios use as an indicator for future out performance. I hope to simply uncover what I believe is misleading and confusing for the people indexing was invented for: people without enough time and resources as an active manager to do research and make adequate investment decisions (this is debated though). In other words, the general public, the blue-collar and white-collar middle class of America.
Spend 5 minutes surfing Vanguards website, and this idea is reinforced:
(Highlighting is mine; https://investor.vanguard.com/etf/)
This snapshot from vanguard's website is not necessarily talking about index ETFs specifically, but it is claiming that their is less risk, less work, more convenient when buying a Vanguard ETF. Going further, when looking at VOO, Vanguard's S&P 500 ETF, we see the p/e ratio advertised as 27.6x.
(Vanguard ETF Profile | Vanguard; data 12/23/2020)
When you click on the "Price/earnings ratio" link this is the definition that comes up:
Interestingly, Vanguard claims that for a portfolio, the ratio uses weighted average rather than a harmonized average p/e ratio. Looking at the fact sheet Vanguard provides for this ETF provides no further detail as I could not find a disclosure talking about how the p/e ratio is calculated. (Source)
I was glad to see that Vanguard advertised that their p/e ratio utilized the weighted average method. More on this later. I highly suspect this is just the work of bad disclosure of what is going on, but I could be wrong.
People can think logically and act rationally when they work with facts (for the most part):
As a presupposition and as a value investor at heart, much of what goes on in the market with M&As, IPOs, the disconnect between the market and the economy and company valuations strikes me as nonsensical and frankly illogical. No one is perfect in their decision making, especially when money is involved but I tend to believe that when armed with accurate data, quantifiable by the masses, understandable by most, people will act rationally. It is when people are mislead, don't know how to do good research, or choose to disregard good data that irrational, malicious and foolish decisions are made. A harmonized average p/e ratio is misleading and leads people to think they are actually exposing themselves to a lower p/e ratio than in reality.
So what is the harmonized average of a p/e ratio and why is it so dangerous?
An Index ETF has a simple goal, to replicate with the lowest margin of error the performance of the underlying index. For the most part Index ETFs are good at accomplishing this. For example the S&P 500 index we all know and love (or hate) is, give or take a stock or two, a compilation of 500 of the largest publicly listed equites in the U.S. market weighted by market capitalization. What this means is that the bigger the company the bigger the impact it has on the fund. For example, if one company makes up 25% of the index and that same company was down 50% that would have an -12.5% effect on the index (50*.25=12.5). This is all fine and good. Your "risk" is spread out over 500 companies, the biggest companies giving you the biggest booms or busts. You would think that since this is how the index is built and how your performance is calculated, as a weighted average, so would the p/e ratio you see on almost ever Index ETF fact sheet.
This is where we take a hard left turn, and I mean hard. The p/e ratio, rather than a weighted average is calculated using a harmonized average. Within mathematics, a harmonic mean is utilized when the average of a set of numbers is desired to be calculated no matter the weight each number may be representing. A weighted average takes into account the weight each number represents. So what is the big deal? The harmonized average p/e ratio is not the p/e ratio an investor is actually exposed to. It is the average of each company's p/e ratio equally weighted. For performance purposes, AMZN makes up around 4.6% of the S&P 500. If Amazon is up 30% in one year it would add 1.38% itself to the index performance and the corresponding ETFs. For p/e ratio calculations, Amazon's p/e ratio is 93.28 (Source). It's position of 4.6% in the index would mean that it alone would add 4.29 points to the index's p/e ratio, if a weighted average calculation is used.
Instead though, many ETF issuers utilize the harmonic average which applies an equal weight to all companies in the index. Even though Amazon occupies a significant portion of the index, for p/e calculation (if the harmonized average is utilized), its p/e ratio only accounts for approximately 1/500 or 0.2% (.002) of the index or 0.196 points in the p/e ratio.
How do some of the popular ETF issuers and marketers advertise the p/e ratio? How do third party firms utilize that data? Case study: SPY
Here is the link to the SPY Fact Sheet pulled on 1/28/2021: Source.
The P/E Ratio is listed as 24.85. More importantly it is advertised as the P/E Ratio FY1, meaning it is looking back over the last 12 months for its data.
Scroll down to the very bottom of the next page, within the disclosures, which I bet most average investors do not read you get this definition for the Price/Earnings Ratio FY1:
You also find this for the Price/Book Ratio:
If you aren't bothered like me, maybe this will get you going!
They advertise the weighted average of the Index Dividend yield! So what do we do with all this information and why would this information be advertised in such a misleading way?
Incentive
Understanding incentive in all areas of life is crucial. low p/e ratios historically produce better performance, so why not make funds more attractive by making it seem like p/e ratios are lower? Obviously, p/e ratio is not the only measure of success and sometimes it is a bad indicator of the short-term performance of a stock, industry or entire market. The fundamental bias though is that lower p/e ratios are a good indicator of future performance. So why would a fund company not clearly advertise what the p/e ratios actually is? Well, all I will say is that SPY has almost $500B in the fund and that needs to be protected.
What p/e ratio is an investor actually getting when investing in SPY?
If actual weighted averages are used to calculate the p/e averages I suspect index returns would be much lower and p/e ratios much higher because the p/e ratio the average investor would be exposed to, according to my math, is about triple what is reported on the SPY Fact Sheet found above.
Here is my spreadsheet: SPREADSHEET
According to my calculations the Price/Earnings Ratio Weighted Average is right around 65. Will investors care? What are your thoughts?