Is a bubble forming in the ETF industry?

The tremendous demand for ETFs could spell their ultimate destruction

Is a bubble forming in the ETF industry?
ETFs provide many benefits when compared to mutual funds, including increased diversification, lower cost, and better liquidity. But according to one expert, the ongoing rush into the vehicles may expose investors to more risks than they realize.

“One of the issues is an ETF is not the same as a mutual fund,” said John Stephenson, president and CEO at Stephenson & Company, in an interview with BNN. “In the case of an ETF, you have a designated broker because it’s traded like a stock ... If they can’t find available stock [for the holdings of the ETF], they’ll be buying derivatives.”

According to Stephenson, that can be an issue in esoteric markets, such as the one for lithium, where there are a smaller number of stocks being traded. It’s also problematic when only a handful of names account for the success in a particular sector, in which case the sheer demand for shares in successful companies could overwhelm the available stock, forcing designated brokers for ETFs to buy options, derivatives, and futures instead of the underlying assets.

“What happens if it’s a reversal and you’re selling it?” he said. “[Buying options and derivatives exacerbates] moves on both the upside and the downside.”

The risk scenario for ETFs is especially stark in the US, where the number of ETFs exceeds the number of stocks listed and ETFs account for over 30% of trading in the markets. In Canada, ETFs had around $130 billion in market capitalization as of June 30, while mutual funds have $1.4 trillion. But while the Canadian market is smaller, the relative risks investors face may be the same.

“We’ve got a less liquid market to begin with [in Canada], so I think in terms of relative scale, it’s pretty much equivalent,” Stephenson said. “We just have less underlying to buy. We just have a smaller market.”

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