Are ETFs about to Bubble Out of Control?



Are ETFs about to Bubble Out of Control?


Exchange-traded funds (ETFs) are experiencing record inflows in 2017. Through the first half of the year, U.S. investors have put $391 billion into ETFs, which has already eclipsed the record $390 billion ETFs collected in all of 2016. Their record growth is occurring primarily at the expense of actively managed funds which continue to see record outflows. It’s no secret why ETFs are attracting investors’ money – passively managed index funds have been outperforming active funds consistently over the last decade, charging a fraction in management fees. The shift to low-cost funds has been viewed as a massive transfer of wealth from over-priced fund managers to investors, which continues to drive the growth of ETFs.


ETF Alarmists See a Bubble


Now experts in the securities industry are sounding the alarm over the possibility that a powerful ETF bubble is forming, which is putting ETF investors at risk of another market crash. Many contend that, the sharp increase in ETF inflows require that the funds’ managers continuously buy up shares of stocks in the index they represent, regardless of their fundamentals or whether they’re over-priced. This has, according to the alarmists, driven up stock prices well beyond their fair market value, in effect, creating an asset bubble, which they compare to previous asset bubbles.  As new money continues to pour into ETFs, the prices of stocks being bought rise further. ETF investors are not concerned whether stocks in the portfolio are over-valued. They only care that they own a representative slice of the market.


According to the alarmists, the immediate impact on ETF investors will be felt when they panic and try to sell their funds during a sharp market downturn. If ETF investors try to sell their funds too quickly, it could create a liquidity crisis because fund managers will not be able to sell shares fast enough; there won’t be enough buyers for the stocks which could accelerate their price decline.


Of course, that leaves ETF investors wondering if this is nothing more than hyperbole pushed out by money managers and others who have been impacted by the loss of investment fees; or whether there could be something to it.


There is no Bubble


Well, for every argument put forth by the alarmists about an impending ETF implosion, there is an equal argument to counter it. The first thing ETF investors need to realize is that there can’t possibly be an ETF bubble. That’s because ETFs are not assets; they are merely vehicles that carry assets. The only bubble that could occur is with the assets inside of an ETF. There are more than 3,500 equity ETFs that invest in hundreds of different indexes and market sectors worldwide. Less than 37% of all equity investments are held by ETFs. While it’s possible for an asset bubble to occur within a particular class of stocks held by an ETF, it is all the more reason why ETF investors should diversify their portfolio across multiple indexes and sectors. Should one ETF experience a sharp decline in value, it would only affect a small portion of the overall portfolio.


As to the argument that ETF investors might panic and try to sell their shares into a liquidity crunch, the same argument was made for investors in mutual funds and defined contribution plans, both of which are vehicles for carrying assets. The managers of these funds and plans would have to sell shares so quickly they would run out of buyers, creating a liquidity crisis which would drive share prices even lower. What the alarmists can’t explain is why that didn’t happen during the 2001 and 2008 stock market crashes. While panic selling did occur, it did not cause the implosion of mutual funds or any retirement plans.


Invest Smart to Reduce Risk


Although ETFs have yet to be tested in such a situation, investors can build a margin of safety by ensuring they are well-diversified. ETFs are low-cost and trade like stocks on the stock exchanges, so it’s possible to own several from different indexes and sectors throughout the world. Also, only select ETFs that have a higher daily trading volume. This could reduce the possibility of running into a liquidity crunch when the market sours. Better yet, seek the guidance of a professional money manager who trades in ETFs. They are best positioned to help you select ETFs that match your investment profile and achieve optimum diversification at the lowest cost.




Vitali Butbaev