Could ETFs, or exchange-traded funds, cause the next stock market crash? With their meteoric rise in popularity over the last decade or so, experiencing 18% annual growth since 2009, some investors fear ETFs are radically overinflating the overall market. Are ETFs forming a bubble set to burst and bring about the next 2008-level market downturn?
ETFs inflating the market and causing the next big crash is likely a myth, as they reflect asset prices within their portfolios. Investments, such as ETFs and mutual funds, do not move the stock market themselves, as ETFs only make about 5% of the global equity market.
Please read on to learn more about this conversation around ETFs, how they work, and how they may or may not impact the next financial market crash.
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Where Did the ETF Crash Story Come From?
Famous short-selling hedge fund investor Michael Burry is one vocal advocate for warnings about an overloaded passive investing sector. Burry has previously warned of a bubble from the massive global investments flowing into passive index funds. He is not the only one.
Michael Horan, head of trading at BNY, has also expressed fears about an ETF-based bubble on CNBC.
Burry’s thesis, according to an article quoting him in the SwitzerDaily (link in article sources below), is that passive investing strategies, such as with most ETF investments, do not allow for the necessary price discovery mechanisms that an efficient market requires.
This would mean that the heavily indexed stocks, such as the companies in the S&P 500 and NASDAQ, are less accurately priced (i.e. overvalued) currently thanks to the rise of ETFs. The rising usage of ETFs in company 401k plans and in robo-advisors portfolios means that all the major stocks being indexed for these funds are becoming overvalued as a result.
Though the author of the article goes on to dissuade the reader from worrying about the grave prospects that Burry presents, there is likely some underlying economic rationale to his theory.
Part of the reason why discussions of a “bubble” (per Investopedia, an overpriced market set to inevitably crash) have become valid around ETFs is due to their rapid growth via mass adoption from the investing public in a short period of time.
Trillions of global investment dollars have poured into ETFs over the last few years, as investors increasingly seek to build their wealth through such passive index fund strategies. John Bogle, the founder of Vanguard, is one of the pioneers of the passive style of investing, whose business now dominates the field.
Active strategies are now even common with ETFs as well.
Visual Capitalist has a comprehensive report on the rise of the ETF as an asset, showing that as of 2019, there were over $4 trillion of assets under management (AUM) within exchange-traded funds in the United States alone. And ETF investments have only increased since then, according to the Wall Street Journal, to a balance of over $9 trillion globally.
Naturally, in finance, when industries grow this hard and fast, there is good reason to believe that a bubble has formed and a downturn is inevitable.
But is that true? How do ETFs really work?
ETFs: Cause and Effect in the Market
The publication Investment Executive addresses this question of ETFs and the possibility of them leading to a market crash. They present a couple of evidence-based reasons to support their argument that fears of an ETF-caused market crash are more fiction than fact.
First, ETF prices are market-dependent. As investment vehicles track many different stocks, these funds react to the overall movement of those company’s stock price fluctuations. Investment Executive quotes Kevin Gopaul, head of BMO Global Asset Management,
“ETFs are priced based on their underlying portfolios, not the other way around.”
In sum, ETF prices are an effect of the overall financial market’s price movements and not a cause.
The primary cause of most global equity market movements is overall industry operations, such as sales growth or labor shortages, as well as exogenous events, such as pandemics and political changes.
The second reason why these bubble fears are overblown, while ETF investments have skyrocketed after the turn of the millennium, is that they still only make up a fraction of the total equity market.
Total ETF asset value makes up about 5% of global equity.
That is not a serious enough influence on the total market. This limits their reach upon global market fluctuations, even if they have formed a bubble as some pro investors, such as Burry or Horan, believe.
Other publications, such as Fortune and ETFStream, mirror such a counterargument that concerns over an ETF crash are likely overblown. They are worth discussing, however, as they help investors learn more about how the market and these assets work.
ETFs Could Contribute to the Next Crash but Are Unlikely To Cause It
ETF price volatility is based on the collective volatility of the stocks within their portfolios. They are securities that primarily track collections of stocks and do not themselves produce volatility, but rather, they reflect it.
Though some do experience liquidity issues depending on their trade frequency, ETF investments do not contribute significantly to equity bubbles. As far as there may currently be an equity bubble, ETFs would be only one of many, many factors.
The stock market is a very complex beast, and there are no guarantees, especially about where the next crash may source from. But it is unlikely that ETFs, in whatever capacity they may influence overall market moves, will be the first or most important domino.
The buying and selling of ETFs, to the tune of $9 trillion AUM, is likely to just mirror whichever way the rest of the market is going, whether towards greed or fear. In this way, the ETF “bubble” will likely contribute to the next crash, as many other factors just as well, but should not be the leading cause.
The Investment Executive further lays out the bare fact that every market crash is caused by aberrant human behavior. A look at the history of bear markets and crashes, and the pattern is usually more egregious than just the introduction of a new investment type.
There have been three major crashes or bear markets within the last 20 years.
Overly eager early Internet investors, along with geopolitical unrest in 2001-2002, caused a crash in the stock market.
The big banks selling highly risky yet lucrative mortgage-backed securities feeding an overinflated real estate market in the years leading up to 2008 caused a crash. ETFs are an investment vehicle that reflects the stock market’s flux.
The unexpected coronavirus pandemic caused a micro-crash and short-term bear equity market, before quickly recovering, during 2020.
ETFs are definitely influential. They are influencing how investors invest, especially younger investors.
The stocks at the top of the major indices, such as in the S&P 500 and the NASDAQ, may even experience sustained investment demand because of their mass listing within the biggest ETFs and mutual funds.
But ultimately, ETFs are not the cause of volatility but their recipient. This dynamic makes them unlikely to cause the next global market crash.
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Conclusion
Due to how they are structured and, despite their rapid growth, only making up a fraction of the total equity market, ETFs are unlikely to cause the next market crash.
Market volatility, and market crashes, source from human behavior. And human behavior, in the economic arena at least, often sources from the shifting material conditions of labor forces and corporate assets employed toward generating revenues and expenses.
In all, no one can really know where the next financial crash will source from, but ETFs are unlikely to be the primary factor behind it.
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