ETFs and Index Funds – A Bubble?

The Exchange Traded Fund (ETF) has been a reliable source of market-linked returns for investors since its inception in January 1993 with the S&P 500 SPDR. An ETF tracks an index or a basket of securities, usually stocks, in order to provide passive levels of returns for investors (i.e. just the market level of return). This differs from the role of an Active fund, such as a mutual fund, which is managed by a fund manager and a team of analysts who try and beat the market’s return. Due to the expertise required, Active funds charge far higher fees to investors (averaging around 1.4%) when compared to ETFs which boast an average expense ratio (fee) of 0.44%, according to Morningstar Investment Research.

Over time, there has been growing scepticism over active managers’ abilities to consistently beat the market’s return. This, coupled with the expensive fees for actively managed funds, has contributed to the meteoric rise of the ETF and indexed funds, which now account for over half of fund activities in the USA. This rise, however, has not gone unnoticed, and some believe that the popularity of indexed funds could have a damaging effect on the global economy if they were to distort the financial markets.

This was brought to mainstream media attention when Michael Burry, of Scion Asset Management, and whom you may know as being portrayed by Christian Bale in The Big Short, mentioned the possibility that indexed funds could be inflating stock market prices, creating a bubble. Naturally, this has increased scepticism of index funds and has generated a level of hysteria around the subject – after all, the man predicted the collapse of the US housing market in 2008. Whilst Michael Burry has become synonymous with predicting doomsday, and that he is undoubtedly a very intelligent person, I think that the level of worry surrounding indexed funds is disproportionate. Here’s why.

One of the key points raised is the impact on Price Discovery, whereby prices are naturally found on markets through trading activity. There are worries that people buy ETFs based on performance, ignoring the fundamental analysis of each individual stock. This risks inflating the value of indexed stocks above their true value, simply because they’re part of a popular index. Another issue is that this process is self-fulfilling. As people buy more shares of an ETF, its value rises, signalling its performance to other investors, who in turn buy more shares, raising the value again. All the while, the intrinsic value of the stocks may not actually be any higher.

However, this doesn’t consider a key feature of ETF trading – it takes place predominantly on secondary markets. Owners of ETF shares often trade directly with other prospective owners, so the asset value often remains unchanged as the shares are exchanged. As shown on a 2017 report by Blackrock, the ETF creations that impact the price of the underlying assets represent a small fraction of the overall equities trading volume in US markets. In fact, 5% of trading is done in indexes, compared to the other 95% stemming from active mandates. This trading volume is a more relevant figure than the proportion of the market that is indexed, showing that the impact on price discovery may be more limited than at first glance.

Perhaps a more nuanced point made by Michael Burry regarded the distortionary effect of indexed funds. An indexed stock that’s included in a popular basket will automatically gain value on the market, which may be overvaluing some stocks and widening the gap in value growth between small and large-cap stocks. Usually, growth in small-cap stocks is set to outstrip large-cap in the long run, although times when this has reversed have preceded recessions, such as in the late 1990s before the dot com bubble burst.

Conversely, this point shows that the swapping of these equity growths is not new. In fact, according to John Bogle (of Vanguard Asset Management), index funds made up only 3.3% of the US stock market in 2002 – a figure which reached 15% by 2018. If you still observed small caps growing slower than large caps whilst the size of the passives market was much smaller, then I doubt that the recent rise in passives is responsible for this existing trend.

It’s clear that the concerns about ETFs are not completely unfounded. There should always be consideration for any theories, however outlandish, that are supported by evidence. That said, I can’t help but feel that the worries about ETFs have been dramatized, especially since the continued success of index products will outshine some underperforming active fund managers, giving some a motive to scare people away from ETFs. It’s always worth keeping an eye on trends in data, but do I think an index fund bubble will bring the equities market to its knees? Perhaps not.