It’s nearly the end of another year – and that means a new round of predictions and prognostications about what’s in store for the market in 2018. Just like in recent years, all eyes are on exchange-traded funds as the locus of the next big bubble.

The reasons for concern are not hard to understand. The broad stock market has been on an upswing, with the S&P 500 up over 16% year-to-date as of November 26, 2017. Massive inflows into ETFs have helped fuel that rise. But some analysts are calling for a big selloff next year and just the sheer number of ETFs make the products at risk for a retreat. A recent report from FactSet shows that half of all ETF inflows are going to roughly 1% of the ETF market; that means the rest of the 2,030 exchange-traded products on U.S. exchanges are fighting over the rest of the money.

Focusing on ETFs traded on the NYSE Arca alone, where 1,450 products are listed, there were ETF assets under management of $2.61 trillion as of September 30, 2017, the most recently available statistic, with an average daily turnover exceeding $66 billion.

Index ETFs, those passively managed funds tied to a major index, accounted for 30% of all equity trades in the US last year and that number could be as high as 40 percent for 2017. (See: 5 things you need to know about index funds).

 In 2016, 14 of the 15 most actively traded securities in the U.S. were ETFs – led by the monster index ETF SPDR S&P 500 Index ETF (SPY), with over 100,000,000 shares changing hands every day. That trend has continued in 2017.

Other heavily-traded index funds included the iShares Russell 2000 Index ETF (IWM), iShares MSCI Emerging Markets ETF (EEM) and PowerShares QQQ Trust ETF (QQQ). (See also: The Top 4 Funds to Track the Nasdaq.)

ETF Bubble Concerns

The investor pendulum has definitely shifted toward passive investment strategies using index ETFs. 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.)

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