The financial markets have historically gone through investment product fads. I previously wrote about how hedge funds are having a very difficult time delivering sustainable positive performance given their popularity and explosive growth. Technology mutual funds ascendancy by the end of the 90’s offers another example. Their surge in popularity during the technology bubble helped to exasperate the overvaluation in the tech sector at the expense of other quality blue-chip equities.The latest fad that has shown substantial growth over the past decade has been the Exchange Traded Fund (“ETF”). An ETF is an investment company or unit investment trust whose shares are traded on stock exchanges at market determined prices. Investors can buy or sell ETF shares much like any publicly traded company. According to the 2011 Investment Company Fact Book, the total number of ETFs has grown from 80 in the year 2000 to 1134 by the end of 2011. Total assets invested in ETFs were $66 billion in 2000 but have grown to $1048 billion by 2011, a compound annual growth rate of more than 28 percent. This is explosive growth to say the least.The proliferation of ETFs has helped to accentuate the flow into indexed based products. With the increased popularity of ETF and mutual fund indexing we are beginning to see some potentially interesting effects on the prices of individual stocks. These passive investment vehicles buy and sell stocks not on merit but only to maintain certain weightings within their structures. There are exceptions, of course, but the bulk of ETF usage is in the form of standard indexation and thus stocks often found in the indexes are bought and sold more frequently. In fact the liquidity and daily trading volume of some larger ETFs now exceeds the liquidity of the stocks which comprise the index. As a result we may be seeing a distortion in prices.With massive flows and mindless buying some stocks get left behind. It is actually creating valuation dispersions. Steve Bregman from Horizon Kinetics has noted one very interesting discrepancy in the Real-Estate Investment Trust (“REIT”) market. Take a look at the two tables I have reproduced below from Bregman’s letter. The first shows the popular REITs held in a majority of ETFs. The second consists of the neglected REITs, those not commonly held in ETFs.As is evident from metrics displayed the valuation gap is very noticeable. The popular REITs trade at higher price to book multiples (they are more expensive) and they actually yield less than the not so popular REITs. Furthermore, the not so popular ones could be considered less risky as they have lower leverage as indicated by the lower debt to equity ratios. The neglected REITS offer an investor cheaper valuations, with a higher yield and with less risk.Bregman notes that this “exercise could be repeated with virtually any other industry sector or even asset class”. If you ever wonder why active managers have trouble outperforming their respective indexes it’s probably because they aren’t really active managers. They likely own too many stocks with many in the popular indexes and thus they are missing some of the neglected but more valuable companies. The ETF indexing bubble looks like it could be offering savvy investors a chance to outperform the market by constructing portfolios that look dissimilar to popular indexed constructs that offer greater reward for the risk taken.Disclaimer: This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and nonproprietary sources deemed by Anchor Investment Management Ltd. to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. Past performance is no guarantee of future results. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader. Investment involves risks. Readers should consult their financial advisors prior to any investment decision.