Are ETFs creating a stock market bubble?

Constantinos Antoniades & Milen Yadav

 

 


An ETF (Exchange-Traded Fund) is a type of financial security that monitors the performance of an underlying index. They are traded on exchanges (unlike mutual funds) and can be bought and sold throughout the day like any standard stock. They contain different asset classes such as stocks, bonds, and commodities. An example is the Vanguard FTSE 100 Index fund that replicates the performance of the FTSE 100 Index (made up of the largest 100 companies listed in the London Stock Exchange).



Figure 1: A comparison of the cumulative and discrete performance of an index fund and ETF

Source: Trustnet, Vanguard FTSE 100 Index Unit Trust A Acc GBP


ETFs have heavily increased in popularity in recent years, as shown in Figure 2, for several reasons. They have lower costs and fees in comparison to other financial securities, particularly benefitting passive investors (gradually building wealth over time by tracking the market). Furthermore, they can be traded at any time throughout the day, unlike mutual funds where prices are only updated at the end of the day. Lastly, ETFs consist of a range of securities; hence you are splitting your money across multiple sub-markets, reducing risk.


After reading about the advantages of ETFs, you may question why such a beneficial financial instrument can potentially cause the stock market to crash. Michael Burry, a hedge fund manager that partially predicted the 2007 Financial Crisis, recently gave his outlook on ETFs. He implied that a market crash is looming due to a rise in passive investing. “ETFs do not require the security-level analysis that is required for true price discovery”. The ease of investing in such instruments is causing huge inflows of money, distorting the price and causing rapid growth. The market bubble will continue to increase in size as long as this phenomenon exists, hence the market crash will have an increasing impact on stakeholders.



Figure 2: Cumulative equity fund flows* since 1996 ($bn)



Source: BofA Merrill Lynch Global Equity Strategy, EPFR Global, Lipper



Figure 3: Changes in the market price of the NASDAQ Composite index fund between 1983 and 2002

A market bubble exists when securities are

traded at prices considerably higher than their intrinsic value. The rise in value of the asset is not supported by its underlying demand, hence it is over-inflated. Eventually, a market bubble will ‘burst’, leading to severe depreciation of assets. Investors could lose money if their portfolio is not fully diversified. There are significant macroeconomic effects associated with this such as a fall in consumer confidence, lower consumption and therefore lower aggregate demand. Figure 3 shows the effect that the infamous ‘Dot-com’ market bubble had on the Nasdaq Composite Index (includes

Source: NASDAQ almost every security listed in the NASDAQ exchange).


“From 1996 to 2000, the NASDAQ stock index exploded from 600 to 5,000 points”

This was a time of great optimism due to the rise in popularity of early internet companies, called ‘Dot-coms’. People heavily invested in companies that lacked strong foundations and consistent earnings. “Within months, the NASDAQ stock index crashed from 5,000 to 2,000”. This caused investors to sell their financial securities out of fear and panic, leading to a stock market crash.


Despite passive investing and ETFs’ increase in popularity, we need to take into account the influence that active investors have on the stock market (ongoing buying and selling of shares to outperform a benchmarking index). Figure 4 shows that the amount invested in active funds surpasses that of passive funds, suggesting that active investors have a greater influence on the fate of the stock market. However, it is worth noting that the difference between them is shrinking.


Figure 4: Chart showing a comparison of the amount invested in active and passive equity funds between 2008 and 2018

Source: Bloomberg


The term ‘float’ refers to the number of shares that a company issues to the public that are available for investors to trade. This can be used to predict the influence of ETFs on particular companies. For example, if 30% of Facebook’s floating shares are owned by ETFs, a market bubble is likely to affect Facebook and its investors greatly. Statistics show that ETFs own only a fraction of many blue-chip stocks (shares of large, reputable companies). “Around 5% of Microsoft and Amazon’s floating shares are owned by ETFs”.Therefore, you can argue that active investors have a significant amount of power in setting prices.


To conclude, the evidence shows that despite there being a large increase in the popularity of ETFs, their impact on the overall market is minimal compared to that of active investors. “Index fund investors are essentially buying what the active investors have laid out to them”. However, the possibility of a stock market bubble is a valid argument that can’t be ignored.


 

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