INVESTED: In Markets, in the Future, and in Society.

Bursting the ETF Bubble Myth

With financial markets on a roll in 2021, exchange traded funds (ETFs) drew a fair amount of criticism for their perceived role in lifting stock markets to new highs. Though monetary policy and central banks might have been “public enemy number one” in the eyes of underperforming stock pickers, ETFs were a close second. Most criticism followed a similar pattern of suggesting that the rise in the popularity of ETFs has inflated equity valuations, with fabled stock picker Peter Lynch criticizing ETF buyers, saying “this move to passive is a mistake.”

Last week, the CFA institute released a blog post (authored by Nicolas Rabener) expunging the myth that ETFs are “the tail wagging the equity market dog,” and there are some relevant points to highlight. Namely, even with global assets under management (AUM) of ETFs reaching close to $10 trillion, ETFs are not even close to overpowering fundamental forces. As this blog post highlights, “active” equity mutual funds and ETFs (as well as indexed equity mutual funds and ETFs) own only 28 percent of US stocks as of 2020, up from 26 percent in 2010. The rest of the stock market is owned by pension funds, hedge funds, insurance companies, family offices, and retail investors.

You’ll notice that I put “active” in quotation marks, as the line between “active” and “passive” gets increasingly blurred when referenced in investment management. You can be an investor in an “actively” managed mutual fund where the investment manager is effectively hugging the benchmark – thus mimicking a “passive” investment as a result of incentive alignment – or you can be in a “passive” ETF vehicle where you are making active bets away from the global market portfolio and using ETF vehicles in an extremely active manner.

Furthermore, even with the increase of new ETF products, secondary trading of ETFs on the stock market hasn’t materially increased since 2011. While you tend to see upticks in ETF trading volume on market declines (ETF products tend to be easier to trade quickly as a way to adjust portfolio exposures), ETF trading volume has remained relatively stable over the last decade. So even with the explosion of Wall-Street-manufactured ETF products dicing up every risk exposure out there – which may not be a net benefit to investors as the original forefathers of index investing had hoped for – we have yet to reach a point where ETF vehicles are distorting the stock market.