Record-breaking inflows into exchange-traded funds (ETFs) this year are fuelling fears that the tide of money surging into passive investment is helping to inflate a bubble in the US stock market.
ETFs primarily offer investors low-cost access to a variety of indices such as the S&P 500, FTSE 100 and Nasdaq 100. Unlike a typical actively managed mutual fund which might be trying to beat the market, such as the aforementioned S&P 500, an ETF tries to reflect the market by acquiring the underlying securities in the index it tracks. Traded like shares, ETFs are quoted on a stock exchange.
Demand for ETFs has accelerated sharply this year, as a growing number of investors move into low-cost funds that track an index, and out of traditional actively managed funds in protest at inconsistent performance and high fees.
Investors have ploughed $391 billion (€330 billion) into ETFs in the first seven months of 2017, already surpassing last year’s record annual inflow of $390 billion, according to ETFGI, a London-based consultancy.
The ETF industry has attracted almost $2.8 trillion in new business since the start of 2008, coinciding with one of the longest bull runs in US stock market history. The US benchmark S&P 500 index hit an all-time high on August 8th, up 267 per cent since its post financial-crisis low in March 2009.
Chorus of criticism
The rise of ETFs has prompted a growing chorus of criticism from some of the world’s most influential money managers, who complain about the effect of passive funds on asset prices and the potential for a liquidity squeeze in times of market stress.
"When the management of assets is on autopilot, as it is with ETFs, then investment trends can go to great excess," said Howard Marks, co-founder of Oaktree Capital, the $100 billion US alternative investment manager.
He cautioned that ETFs’ promise of ample liquidity has yet to be tested in a major bear market.
“It is not clear where ETFs and index mutual funds will find buyers for their holdings if they have to sell in a crunch,” said Mr Marks.
Paul Singer, the chief executive of Elliott, the $33 billion US hedge fund manager, sharply criticised ETFs in a letter sent to investors in late July.
Demand for passive funds has been supercharged by governments' manipulation of asset prices. This has "created the illusion that simply holding stocks and bonds in their index weights and sitting back, arms folded, is the perfect investment strategy", said Mr Singer, according to a copy of the text obtained by the FT.
He added: “What may have been a clever idea in its infancy has grown into a blob which is destructive to the growth-creating prospects of free-market capitalism.”
Central Bank call
Scrutiny of ETFs influence by regulators has intensified. The Irish Central Bank called in May for greater clarification on ETF ownership and pricing and the International Organisation of Securities Commissions, the global umbrella body for securities regulators, launched a consultation last month that will examine potential risks posed by ETFs.
Most of the world’s largest ETF providers have experienced a surge in new business this year.
BlackRock and Vanguard, the world's two largest asset managers, have benefited most. BlackRock has attracted net inflows of $158.9 billion into its iShares ETF arm, already exceeding the $137.9 billion gathered over the whole of 2016.
Pennsylvania-based Vanguard has seen new ETF business reach $91.8 billion, nearing the $96.8 billion gathered in 2016.
Martin Small, head of US iShares at BlackRock, said fears that ETFs were distorting asset prices were misplaced.
“ETFs combined with index products represent $17 trillion in assets, which is around 10 per cent of the market capitalisation of global stock and bond markets. The suggestion that ETFs are driving up the stock market or hindering efficient price discovery is fundamentally wrong and not supported by the data.”
ETFs, said Mr Small, were having a “profoundly positive impact”, helping many more retail investors gain access to robust low-cost investment portfolios. Around 10 million new shareholder accounts have been opened at iShares over the past year, taking the register to more than 30 million accounts. – (Copyright The Financial Times Limited 2017)
