ETFs have become hugely popular recently as they can offer portfolio diversification at a very low fee. However Michael Burry, as portrayed in the “The Big Short” and who predicted the subprime mortgage crisis thinks there is a bubble brewing in passive investing with ETFs. In this article we discuss the impacts of ETFS on the stock markets.

What is an ETF?

It is a fund which usually holds multiple stocks and tracks an asset class or an index traded on the stock exchange. Clients buy units in the fund and do not own the underlying asset.

What is a bubble?

A bubble is created when an asset is trading a price that is significantly higher than its intrinsic value.

How does the ETF track indexes?

The ETF provider buys all the stocks in the underlying index. Another method is by a synthetic replication of the underlying index by entering an equity linked swap.

How does the ETF cause a bubble?

• Popularity of ETFs has been building over time so the longer the bubble runs for, the worse the crash will be. Passive funds have flooded the market to more than $3 trillion in less than 10 years. Active fund managers have not outperformed because of record low volatility in steadily rising markets, so investors have considered passive ETFs as an alternative.
• Large inflows and outflows into the fund can cause market instability. When there are large outflows of the market, there is a rush to exit and the market will find it hard to take all that selling. There may not be enough buyers to take all the investors who want to exit the ETFs which may cause a market crash. The market crash is caused when ETF providers start to sell off their positions in the index.
• ETFs buy stocks in companies which are in the index and this can cause overvaluation as there is a concentration of money in a small number of stocks. For example, the more people who invest in the passive index of the XJO (ASX200) then the more likely the stock prices of these companies within this index are high regardless what their earnings are doing. When the demand for ETFs increases then this means stocks prices of companies in these indexes (which the ETFs tries to be replicate) will continue to increase. This may mean share prices may be distorted as it may not reflect the intrinsic value of stock. There is no price discovery involved with ETFs.
• Equity markets have enjoyed the longest bull run in history. This means that if there is a market crash it be catastrophic. As passive investing ignores price discovery, these increased inflows from ETFs could be pushing the share market to record high territory where it doesn’t really belong.
• There is also risk involved with synthetic ETFS as they rely on derivatives to track the performance of the index. Swap agreements (derivatives) are common products that ETF providers use the replicate the index when it is too expensive or complex to hold all the stocks in the basket. The counterparty which may be an investment bank will pay the ETF provider the return of the index. There is a counterparty risk associated with synthetic ETFs as the investors are relying on the counterparty to keep their end of the bargain and pay what the index is returning. Hence if there is a sell off, then investors may have difficulty liquidating positions.

Lauren Hua is a private client adviser at Fairmont Equities.

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