The real risk hiding inside ETFs

With $330 billion sitting in ETFs on the ASX, the bubble question keeps coming up, and the real risks aren’t the ones most people are worried about.

As you know, exchange-traded funds are extremely popular in Australia. $330 billion of your money was invested in exchange-traded funds on the ASX as of the end of last year. By the end of this year, that figure is expected to reach $400 billion. 2 million of you own exchange-traded funds. And there is a natural fear that this whole thing is a bubble – that there’s something wrong with exchange-traded funds, that it’s all going to go wrong precipitously, and you’re going to be left with no money in retirement. We’re going to have a look at what’s wrong with exchange-traded funds and whether this whole thing’s a bubble.

Concentration and the “big get bigger” problem

So, one of the main risks, criticisms, and problems with exchange-traded funds is that they concentrate money in a narrow number of stocks. And because they do that, the big get bigger. Let me give you the obvious example – the Magnificent Seven. There are exchange-traded funds in the US that focus on the seven big tech stocks. And so the easiest way to get exposure is to buy an exchange-traded fund that holds those seven stocks. And as the money filters into big tech, those exchange-traded funds have to go and buy the stocks, in which case the share prices go up. People get more excited about them, and the weightings of those stocks in their index goes up and up. The big get bigger. And this is one of the problems with exchange-traded funds – it funnels money into small areas of the market, which can create bubbles, if you’d like to call it that.

The second problem is that if you have a group of stocks grouped under a thematic – call it copper, or big tech, or AI infrastructure – the prices of all the stocks in that exchange-traded fund get bought, because that is the percentage the exchange-traded fund holds. It will buy all the stocks, whether they are good or bad. So if you had an exchange-traded fund with one fabulous stock in it and one rubbish stock in it, the rubbish stock sees as much money going into it as the fabulous stock. This is co-movement of bad stocks and good stocks, because of exchange-traded funds.

You’ve probably heard of the efficient market hypothesis, which says that all information is discounted in a price at all times. In which case, you shouldn’t bother trading stocks, because you have no information advantage, ever. Markets clearly aren’t 100% efficient. The idea is that exchange-traded funds are making the market less efficient, because all the money is arriving regardless of the quality of the individual stocks. So some stocks trade above valuation, others below valuation. I don’t mind that either – inefficiency in the market is good. It is something to take advantage of.

Another criticism of ETFs is all part of the same equation, but it’s concentration. If there are particularly attractive themes in the market, those ETFs that represent those themes will get bought, and the money pours into themes. There may be, for instance, ten tiny stocks involved in a particular theme, yet big hedge funds decide that’s a great theme and start putting enormous amounts of money into companies that just don’t warrant that sort of flow. So thematics will attract money and overconcentrate money in areas of the market that really don’t warrant that sort of flow, because people have bought the top-line thematic rather than understanding the individual stocks.

Another comment is that exchange-traded funds are self-reinforcing. Money comes in, prices go up, more money comes in. The idea is that this can create a bubble, and that bubble may well burst at some point. But this is the market – it’s not something that is going to destroy the whole market. It’s something that might create particular volatility in particular stocks and particular themes at particular times, but it’s not really a systemic problem with exchange-traded funds as a whole.

False diversification and liquidity risk

Another problem is false diversification. You may own an ETF over big tech, an ETF over AI, and an ETF over semiconductors, without realising that the same stocks are in all of those ETFs. So you may be looking at three holdings across 50 stocks, but the reality is you’ve actually only got 30 stocks, because they’re all holding the same thing.

Another problem is well understood – it’s a liquidity problem. Now, ETFs – we’ve had experience dealing in tens of millions of ETFs at one time, and we’ve only ever had a problem dealing in one in particular, which was an ETF that represented small companies in the US. Now, there were actually billions of dollars in this ETF, but it took us three days to get out of it. And the reason why is that the ETF is only as liquid as its underlying assets. So if you were holding an ETF that represented small companies, as we did, it took a while for the exchange-traded fund mechanism to sell those stocks. So our execution wasn’t done on day one easily. If we were dealing in the Magnificent Seven, it would be done in 30 seconds. Generally speaking, liquidity is great, but it’s only as good as the underlying stocks.

Hidden complexity in derivative-based ETFs

And another issue with exchange-traded funds is hidden complexity. You may not understand that a lot of exchange-traded funds, if they do something like gear you to the S&P 500 so you get double the return of the S&P 500, or it’s an inverse ETF so you make money when the S&P 500 goes down – all those sorts of exchange-traded funds are constructed using derivatives. Derivatives have a natural time decay. So the value of the ETF slips and slides – it doesn’t stick like a passive ETF following the S&P 500 two times or minus one times. It is losing money because of the derivatives expiring, time value leaking out. Just be aware there is complexity in some exchange-traded funds, and that can be a bit of a problem should a seismic event appear.

The ETF bubble question

So let’s get to the big one. Is the exchange-traded fund market a bubble? And if there was some sort of precipitous market event, are people going to be disadvantaged by being in exchange-traded funds, as opposed to being in the underlying stocks? The answer to that is there is no sign of any problem. So far, the exchange-traded fund market went through the global financial crisis without any particular blow-up. It also went through the COVID correction – the market fell over 30% in 30 days – and there was hardly a hiccup of stress from the exchange-traded fund market.

That is not to say you won’t have trouble if the market has a crash while you’re sitting in exchange-traded funds. But you are probably going to find that you would have the same problem whether you were in that structure or outside it. The problem is going to be the liquidity in the underlying assets of those exchange-traded funds, which would be the same whether you were going through a fund or going direct to those assets yourself.

I don’t, from history, see that exchange-traded funds are a bubble, but they are becoming vastly more popular. They are sucking money off other investment vehicles, be that managed funds, mutual funds in the US, or industry funds. Yes, they are growing rapidly, but that is not a speculative bubble – that is a money-rotating bubble.

So whilst I can’t promise you that you’ll be fine in exchange-traded funds when the market crashes tomorrow, and I can’t tell you that exchange-traded funds haven’t caused concentration of money in particular stocks and particular themes – yes, they have. Yes, it’s made the big bigger. Yes, it could get panicky if everyone tries to sell an exchange-traded fund at the same time. There are all sorts of issues like that, but you’re going to have the same problem in the market or in exchange-traded funds. So I think you can pretty much relax about some sort of systemic problem in the exchange-traded fund industry. Don’t think the issuers haven’t thought about it. Don’t think the regulators haven’t thought about it. They have. There is no big problem. I think you can relax.

If you want to hear more about exchange-traded funds, we cover them regularly on the Marcus Today website – sign up for a free 14-day trial. And if you’d rather have us manage it for you, take a look at MT20.