It’s a new year—and that means a new round of predictions and prognostications about what’s in store for the market in 2017. And this year (like 2016 and 2015), all eyes are on exchange-traded funds as the locus of the next big bubble. (See also: Market Outlook: No Bottom Until 2017?)
This year, however, they may have a point. There were 1,944 exchange-traded products on US exchanges as of November 2016. Focusing on ETPs traded on the NYSE Arca alone, where 1,560 products are listed, there were ETF assets under management of $2.2 trillion, with an average daily turnover exceeding $90 billion. In fact, data collected by Bloomberg showed that investors traded $18.2 trillion in ETF shares over a 12-month period last year, easily eclipsing US GDP.
As astonishing as those figures are, they only tell a small part of the story. Index ETFs, those passively managed funds tied to a major index, accounted for 30% of all equity trades in the US last year. In November 2016, the latest month for which figures are available, ETFs made up six of the 10 most actively traded securities in the US—led by the monster index ETF SPDR S&P 500 Index ETF (SPY), with over 100,000,000 shares changing hands every day.
Other index funds in the top ten included the iShares Russell 2000 Index ETF (IWM), which actually beat out Amazon.com Inc. (AMZN) and Apple Inc. (AAPL) in average daily volume, iShares MSCI Emerging Markets ETF (EEM) and PowerShares QQQ Trust ETF (QQQ). (See also: The Top 4 Funds to Track the Nasdaq.)
The investor pendulum has definitely shifted toward passive investment strategies using index ETFs. Consider that last year, Vanguard’s passively managed index funds got more net inflows than the next nine ETF issuers combined, setting a new record in 2015 for annual fund flows according to Cerulli Associates, a global investment analytics firm.
ETF Bubble Concerns
And that’s what keeps market watchers up at night, because it means that a massive amount of investor assets are tied up in the relatively small number of securities represented on the indices. This is especially worrisome after research by S&P Capital IQ discovered a 50% premium on stocks traded on the Russell 2000 over equities not included in the index, a 12% increase over the past 10 years. (See also: S&P 500 Vs. Russell 2000 ETFs: Which Should You Get?)
Could this be the canary in the coal mine? The price differential between index stocks and their non-indexed counterparts suggest the making of a bubble, especially in the event of a downturn. Index stocks trading at a premium could drop faster and more precipitously, putting tremendous pressure on index ETFs.
The problem is structural and arises when the liquidity demands of the exchange-traded funds exceeds the liquidity of the index equities themselves. An investor wishing to dump shares of an index ETF may discover that the fund is unable to sell off the underlying stocks, since index fund managers must mimic, in individual equities and proportions, the benchmark index.
In theory, then, actively managed ETFs are better positioned to navigate a downturn, since they can take proactive steps to balance their holdings as market conditions change.
But just how big is the risk? Perhaps not as large as the numbers appear. The diversity in index funds means that capital is flowing into markets that weren’t indexed before—bonds, emerging markets, niche sectors. And the massive liquidity of the largest index funds tends to favor alert investors.
That being said, however, some money managers are recommending that investors take a close look at diversification with an eye toward balancing index funds with actively managed ETFs. At the very least, look for places where there’s double-exposure to one or more individual equities—be sure core holdings aren’t duplicated across multiple investments, which can happen very easily when you invest in major index funds.
The Bottom Line
It’s impossible to predict with any certainty if ETFs are headed for a bubble, but it’s always a good idea to play defense, especially in a rapidly changing and uncertain market. If you’re concerned about exposure to index equities, it might be prudent to explore some actively managed ETFs. (See also: 3 Actively Managed ETFs Worth the Cost.)