With the return of volatility in the stock market and more money flowing into exchange-traded funds, some experts in the industry claim that ETFs have distorted the prices in underlying securities.
Overcrowding in niche asset classes could form a bubble and in turn, trigger a market crash, according to investment professionals.
In 2017, investors allocated $220.4 billion into U.S. equity passive funds and pulled $207.5 billion out of U.S. equity active funds, according to Morningstar, a Chicago-based investment research firm. The rise in popularity of ETFs has been growing the past several years as some investors favor them over mutual funds since ETFs are more nimble and trade throughout the market day and niche ones have been created for nearly all asset classes and sectors.
[See: The 10 Best ETFs to Buy for 2018.]
The inflows for ETFs reached $464 billion in 2017, according to data from State Street Global Advisors, which owns the popular family of SPDR exchange-traded funds. Mutual funds are becoming less sought after and received only $91 billion of inflows through November 2017, according to Credit Suisse.
The growth of ETFs should not trigger a market crash, says George Mateyo, chief investment officer at Key Private Bank, a Cleveland-based bank. “ETFs are not a leading factor of the current market’s run-up, nor are they inherently capable of initiating a market crash,” he says.
The naysayers have claimed that ETFs provide an outlet for “hot money” and that it leads to overcrowding in this asset while distorting the prices of underlying securities. Their claim is that if the overcrowding begins to self-perpetuate, it can create a bubble.
“While ETFs may allow for ‘hot money,’ they are currently not a large enough portion of the broader market to materially impact aggregate valuations,” Mateyo says.
Instead, in future downturns in the broad market, passive ETFs are more likely to echo the market by tracking their respective benchmarks. “Any slump in their performance should be a symptom, not an underlying cause of the market movement,” he says.
Markets are complex. While many investors look for a single trigger for a market decline, it is not that simple, says Peter Borish, chief strategist with Quad Group, a New York-based asset management firm.
“Markets are complex systems and it is the intersection of many triggers that lead to an accelerated decline,” he says.
The likelihood of a crash in the market is low if it is defined as a decline of more than 10 percent in a day.
[See: 7 ETFs That You Have No Business Buying.]
“While we do not rule a decline that will be defined as a bear market and which may have started at the end of January, predicting a crash and other outliers is tough,” Borish says.
Unlike mutual funds, which can only be purchased at the end of the day, ETFs are traded intraday like stocks, which means some investors might engage in more speculative trading with them, says Charles Sizemore, a portfolio manager for Interactive Brokers Asset Management, an online investing company based in Boston.
“There is really nothing new under the sun here,” he says. “The basic tendency of investors to chase performance hasn’t changed. Back in the 1990s, investors dumped value stocks to pile into technology mutual funds.”
The indexing of stocks, whether they are in ETFs or mutual funds has created a bit of a bubble, Sizemore says. “Investors Bill Ackman, Howard Marks and others have commented on this in recent years and they raise good points,” he says. “There is also the issue of liquid ETFs potentially distorting relatively illiquid sectors like bonds and preferred stocks. Investor herding like this has been a feature of the market since time immemorial.”
Leveraged ETFs carry an extra risk. Plain-vanilla ETFs will not be a trigger for market dislocations, says Robert Johnson, president of the American College of Financial Services in Bryn Mawr, Pennsylvania. Inverse and leveraged ETFs are riskier investments that the majority of individuals should refrain from buying because they could contribute to substantial market movements.
While the SEC denied the launch of two quadruple-leveraged ETFs offered by ForceShares last May, there are 36 triple-leveraged ETFs on the market. Triple-leveraged ETFs offer three times the gains or losses on an index, and can be used to make high-stakes bets that a segment of the market will rise or fall.
[See: 8 Great ETFs That Hold ETFs.]
“These are wildly speculative and inappropriate for the vast majority of market participants,” Johnson says. “Leveraged ETFs may not be weapons of mass destruction, but in the wrong hands they are vehicles capable of significant wealth destruction. The clear and present danger is that do-it-yourself investors who find themselves behind on their savings goals may swing for the fences with highly leveraged ETFs.”
Another issue is that some investors believe that in order to garner higher returns, they need to trade frequently and employ leverage to outfox the market in the short term, Johnson says. Leveraged ETFs are marketed as a method to trade often and obtain leverage.
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Why ETFs Are Unlikely to Trigger a Market Crash originally appeared on usnews.com
