ETF bubble, or risk pockets and distortions?

They may not threaten the broader market, but there are reasons for concern

ETF bubble, or risk pockets and distortions?
As more and more investors pile into low-cost ETFs to access profitable parts of the market, some are warning that the rush into passive investing is creating a bubble that’s just waiting to collapse. One analyst has called the concerns overblown — but acknowledges that risks exist in some areas.

“Chasing performance is not anything new,” Craig Basinger, CFA, said in a note to clients of Richardson GMP. “And we should keep in mind there remains more money in active strategies than passive ETFs, by a considerable margin. Perhaps if there was a bubble bursting, it was the bubble of closet index funds that were charging higher fees.”

Basinger said the firm is dismissing the arguments for an ETF-driven bubble, but sees price distortion and some pockets of systematic risk developing. By analysing ETF inflows into companies on the S&P 100 as well as their performance over the past two and a half years, he determined that they could be divided into two groups based on their price sensitivity to ETF inflows.

“It would appear around the time ETF assets started rising, the performance between ETF Sensitive and Less ETF Sensitive began diverging,” he said. “While there may be other factors at play, it is not inconceivable that broad flows into ETFs may be inflating some companies more than others.”

While Basinger thinks an ETF selloff would not affect the broader equity market very differently compared to previous cycles when investors dumped mutual funds, he said some narrowly focused ETFs with underlying illiquid markets could put investors in those pockets at risk.

“For instance, the money that flowed into the marijuana space certainly caused temporary price distortions in the underlying companies, given their normal lack of liquidity,” he said.

He also cited the high-yield bond market: “If there was a dramatic outflow, given bond inventories at dealers are historically low, this may cause liquidity risk.”

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