Recent financial research suggests that inclusion of a corporate share in an index ETF adds to its market value. As index ETF investor participation grows, overpricing apparently becomes more pronounced. As ETF participation has become a greater share of the investment universe, these effects have apparently become more important. As a result index ETFs may now be both less diversified and overvalued. A return of shares included by ETFs to their fundamental, rationally determined, values would adversely impact an index ETF investment. The effect of the new valuations on index ETF decision-making would be perverse, leading to further investor losses. According to much recent financial research, the market’s focus on index ETFs [such as the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ), the iShares Core S&P 500 ETF (NYSEARCA: IVV ) and the Vanguard Total Stock Market ETF (NYSEARCA: VTI )] has led to overpricing of many of the common shares included in the important indexes, accompanied by underpricing of companies excluded by the indexes, among other pricing anomalies. This mispricing presents a hazard to investors. The only existing investor defense against a return of these overpriced stocks to their rational value is to buy underpriced stocks outside the index ETF with properties similar to the overpriced stocks inside the ETF. How can the simple publication of an index number intended to represent the value of the stock market as a whole change the value of common stocks? The indexes that are the subject of this article are the source of the dominant common stock investment strategy of the moment, the index ETF. For example the Standard and Poors 500 Stock Index (S&P, a value-weighted average of the 500 largest common shares listed on the NYSE or NASDAQ) is the oldest and still the most important example of a traded numerical characterization of the value of the equity market as a whole. Index exchange traded funds (ETFs) are exchange-listed instruments that replicate broad market measures such as the S&P. Index ETFs are big – about 30% of the volume of all investment funds under management. But there may be strange effects of the existence of index ETFs on the prices of stocks that are part of an index. Those effects, or at least the current scholarly take on them, is chronicled in an interesting October 10th article in the New York Times . The Times article points to substantial evidence produced by market researchers that common stocks included in the popular listed indexes are often, by all the usual measures, overvalued relative to similar stocks outside the indexes. In the current financial academic literature, this is a prominent example of market irrationality. It is not rational, the argument goes, for the simple inclusion of a stock in an index portfolio to change investor behavior and thus affect market prices of securities so profoundly. But the evidence points to several effects. It has been clear, almost since the S&P 500 index began to be published, that being newly included in an important index increases a stock’s market value; while a fall into exclusion leads to a decline in market value. But there is evidence of other more profound effects as well. It appears that as a greater share of the market is included in index portfolios, the effects of index inclusion on stock prices have become more pronounced. And the effects may not simply be higher prices of stocks within the indexes, but higher correlations among the prices of stocks within the indexes as well. This higher correlation is particularly interesting, since it has investor risk management implications. If higher past correlation continues, the major indexes no longer perform their function in portfolio theory – risk reduction through diversification. Why? If correlation between investments inside the indexes rises, correlation among instruments outside the indexes rises, and correlation between index-included and index-excluded investments falls, a diversified portfolio must include stocks outside the index. In other words, the behavior of stocks in index ETFs creates a paradox. The effect of index ETF growth is that the index no longer represents a diversified portfolio. Index ETFs are, in this sense, self-defeating. To form a truly diversified portfolio, investors must now add other stocks outside the ETF. The index ETFs are vulnerable to any trading strategy that exploits this mispricing. One trading strategy that a hedge fund might apply to restore rational pricing to the stock market has characteristics that can be found in my SA Instablog: ” A Trading Strategy Based on Index ETF Overpricing. An ETF Defense. ” Investors can protect themselves (imperfectly) now from a return to rational pricing of the shares included by the index ETFs, and simultaneously achieve the portfolio diversification index ETFs once provided, by buying diversified shares outside the ETFs.